If you are not a fan of forecasting, and have no reason to be sure what is going to happen over the next 12 months, it makes a lot of sense to start the year, not with a set of predictions but with two lists – a wish list and a watch list. As well as being good for the spirits, positive thinking is helpful from a risk perspective. It is much easier psychologically to take precautions against a wish not happening than it is to assume that a public prediction will turn out to be wrong.
This, in any event, is very much the way that many fund managers seem to operate. I have lost count of the number of times over the years that active fund managers are heard to say that what we are facing is a stockpickers’ market – or, to put it another way, a range-bound market that will reward those with suitable skills. As far as I can see, this more often than not is also wishful thinking.
Even if it is true in one year, it rarely is in the next. In 2009, did you need stockpicking skills to spot and ride the market rally? Not really. The most important thing was to be in equities at all, and then the best thing to do was chuck away your analytical sensitivities and pile into high beta stocks regardless of merit.
With the market having rallied so strongly since its lows in March, it is easy to say that 2010 will be different. The so-called “dash for trash” may already have run its course. Large cap quality stocks must be the better long term bet at today’s values, but that does not make it a sure thing that the rotation will persist throughout this year. 2010 has started with a bad January for equities and risk assets, which if you believe in such things, bodes ill for the rest of the year.
However these are early days,and although sentiment has clearly taken a turn for the worse in the last three weeks, with the hedge funds mounting a concerted assault on the risks of Government bond defaults in the Eurozone, it is still premature to write off the rest of the year. The Bank of England’s decision to call a halt to quantitative easing is a valiant statement of intent that it wants to return to more normal conditions, but it may yet be derailed by a return of investor nervousness.
Meanwhile, whether or not you buy into Pimco’s “new normal” hypothesis, what is undeniable is that politics has returned with a vengeance to centre stage, and with it the parameters of risk are changing. With unemployment (or the fear of it, as in China) still running high, new political battle lines are already being drawn in many countries. The Massachusetts election result, to give one example, is clearly a potential game-changing event.
For central bankers and politicians alike, operating in unprecedented conditions with the usual inadequate data, the risk of policy errors remains extremely high. The government debt crisis towards which many countries are now hurtling presents plenty of opportunities for false steps, as well as a wonderful scare story for hedge funds to hunt down, as they are doing.
As experience warns us that this kind of environment is one that is full of perils for investors, a measure of caution is undoubtedly justified. In fact, it seems more likely that the markets’ nervous start to 2010 is best attributed to a heightened sense of political risk than to any change in corporate or economic fundamentals, where as far as can be told the recovery in the United States, at least, is so far well up to expectations, with two thirds of companies beating earnings expectations and support from a steep and rising yield curve. The Government debt issue itself is not news, but how well the markets think governments will react to the problem most certainly is.
Top of any wish list for 2010 must be a return to higher interest rates and rising bond yields. Although this prospect is something that seems to terrify many Western governments, faced with spiralling public debt, it is a essential pre-condition of the world returning to normality. A combination of unprecedented public sector intervention and artificially low interest rates, while it may be justified as a short term expedient, is a surefire path to misallocation of capital and economic stagnation. A failed political response to the debt challenge is the corollary for the watch list.
The risk to investors arises from the fact that, while the voters of Massachusetts seem to have recognised the dangers in fiscal irresponsibility, the administration in Washington does not yet appear to share that opinion. Equally concerning is the fact that the Federal Reserve and many other central bankers seem to have become dangerously fixated on low or even negative real interest rates at almost any cost, as if somehow that is a desirable norm, which it most definitely is not.
The point that should worry investors most is that politics is non-linear. The dynamics can change fast and in unpredictable ways. Politicians tend systematically to overlook the second and third order effects of decisions they make today. Given the likely volatility, the odds are that 2010 could be an eventful year, with an emerging story of better-than-expected recovery (as I see it) threatened by shifting investor worries, continued bank frailty and complex but interesting political and policymaking manoeuvring whose outcome is uncertain and imperfectly knowable.
Jonathan Davis 