January 2011
2011 OUTLOOK /// As seen by: Emmanuel Bourdeix, CIO Equity, Asset Allocation and Structured Products and Franck Nicolas, Head of Global Asset Allocation and ALM. "2010 will remain as a year of transition. The slowdown in China and the United States raised fears of renewed recession for the global economy and budgetary imbalances saw the financial markets break out in a cold sweat." 2011, the year of recovery albeit subject to some constraints Inversely, 2011 could be the year of the recovery and healthier forward momentum with: • Continued accommodative monetary policies in the industrialized countries. • Growth more solidly embedded and less dependent on government stimulus. • Continued concerns about public deficits but a real awakening bringing the markets to their senses given that the fundamentals of companies remain solid. • A still-convalescent but steadily-improving financial sector. The risks remain: • At the level of sovereign debt, with speculative attacks affecting a number of regions still possible, that incorrectly-valued assets could be marked to market in bank balance sheets or a lack of coordination at European level lead to renewed doubt. • That excessive upwards pressure on commodity prices could lead to fears of more inflationary growth in the emerging countries or even the first recessionary effects created by the rising prices of some basic resources. Markets outlook Bonds: look to diversify towards credit and emerging debt From a bond perspective, the current trend is the status quo but 10-year German and US bond yields seem to have bottomed. The risk is clearly asymmetric. There is still something to go for in terms of careful management of duration (we could see some phases when rate hikes pick up speed which could hit directional positions) and sources of diversification like high yield in credit and emerging country debt. 2011, the year of equities For equities, 2010 closed with international equity markets some 10% higher albeit with very different individual returns such as the German market’s near-15% outperformance relative to the French market. The conditions are currently in place for 2011 to be a good year for equities, particularly in Europe.
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Double-digit increase seen for European equities Firstly, equities, without being cheap, are trading at reasonable valuation levels while, at 11 times 2011 prospective earnings, the valuation multiple on European equities stands at a historic low. It is difficult, nevertheless, to count on an expansion in this multiple without an improvement in the macro economic environment. A contraction in this multiple is also unlikely unless the probability of a double dip recession increases. Assuming valuation multiples remain stable, 2011 earnings growth could be slightly below 15%, companies still having some potential for margin improvement. Some of this is already priced in. The double-digit upside potential for European equities in 2011 should thus be driven by the resurgence of a theme that was oversold last year and has been wrongly forgotten this year: that of mergers and acquisitions. As in 2010, equities continue to offer a relatively attractive rate of return compared with government and even corporate bonds. It is thus tempting for a company to issue debt to finance buybacks of its own shares‌ or those of another company. Unlike last year, when the volatility of the equity markets was average to high, we are currently witnessing a change in the technical configuration. The daily volatility of the equity markets being limited to +/-1% on average makes it easier and less risky to implement this type of operation. As a result, share buyback and merger and acquisition transactions should see significant volume growth in 2011, underpinning some 10% upside for the European markets. The resurgence of this theme will be particularly beneficial for small and mid caps, which should continue to outperform large caps.
A preference for developed country equities In terms of geographical allocation, emerging country equities have significantly outperformed those of the developed countries for a number of years. The growth differential in favor of the emerging markets is now starting to be fully reflected in valuations. Without calling into question a positive medium/long-term view, a more cautious tactical approach is required on emerging markets. The overly-rapid appreciation in emerging currencies and the inflationary pressures constitute real shortterm threats, particularly for the three largest markets: Brazil, India and China. As we begin the year, our preference is for developed country equities, particularly US and above all European. The latter have significant catch-up potential once the risk aversion on peripheral sovereign debt starts to recede. Within the emerging countries, a more cautious approach is required to three of the BRIC countries. The positive surprise could come from emerging Europe, the Cinderella of 2010 given the emerging flows directed at Latin America and emerging Asia, largely due to its proximity to the euro zone with exposure to sovereign risk issues. The weight of Russia in the capitalization of these markets and its exposure to the commodities theme is another reason to believe that emerging Europe will outperform this year. 2011, could also be the year of greater sector diversification. Given their outperformance relative to defensive stocks, we would not prioritize the cyclical sectors. European financials should gradually gain strength as sovereign risk recedes. Within the financials, despite the impact of Basel III, the markedly steeper yield curves on average this year should enable the retail banks, who borrow at short rates to finance long-term credits, to post significantly higher earnings.
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Remain flexible We should see double-digit gains for European equities and periods of low realized volatility due to abundant liquidity and significant earnings growth. Macro-economic views remain, however, very divergent. Unlike the equity markets, the fixed income markets, which are often the forerunners of equities, have already seen increased risk aversion over the past few months. Periods of sharp sell-offs should thus still be expected. The emphasis will need to be on a flexible tactical approach so as to take advantage of market opportunities and build positions in the asset class that we see as the most promising for 2011: equities. The attraction of emerging currencies In terms of currencies, while emerging market equities will be somewhat penalized by the uncertainties linked to inflation in these zones, emerging currencies will remain attractive. The likely monetary tightening in a number of zones should effectively continue to be supportive for currencies within an investment industry where the quest for yield is universal. Commodities to continue to forge ahead Given their direct sensitivity to growth, commodities should continue to forge ahead. Oil could plateau even if a move above $100 during the year is more than likely. Industrial metals and agricultural commodities have even greater upside potential. On the other hand, gold, given its capacity as a safe haven, loses some of its relevance in this configuration.
Written 31/01/2011 by Emmanuel Bourdeix, CIO Equity, Asset Allocation and Structured Products and Franck Nicolas, Head of Global Asset Allocation and ALM.
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