There’s no question volatility was once again at the forefront in 2010. Having started the year off right, the markets quickly deteriorated in the second quarter before surging ahead again in the third and fourth quarters. This type of volatility is likely to continue over the next couple of years as markets respond to an economic and corporate picture that often changes month to month.
But in all of this upheaval, there are some areas to keep an eye on when it comes to capital markets. Here are 11 areas of note.
1. Corporate earnings continue to rebound
The economy is in a much better position today than it was two years ago during the financial meltdown. Corporate earnings are bouncing back, and the economy is starting to grow again—albeit at a slower pace than most had anticipated. These are positive factors that markets had overlooked amid too-high expectations following strong market appreciations in 2009.
2. U.S. housing market still needs repairs
One area of concern is the housing market, particularly in the U.S., where there may be further price declines as the supply of homes significantly outpaces the demand, with no real end in sight.
Foreclosures continue to increase, adding to the pricing pressure. Given that prices and mortgage rates are so low, the affordability of buying could not be better. However, this has done little to spur sales, indicating that we are likely going to be in a multiple-year drought in this market.
3. Canadian economy expected to slow
Canada has been fortunate to have sidestepped many of the market and economic pitfalls experienced across the rest of the globe. Our banks are considered among the strongest in the world, our housing market has remained relatively stable and our currency is approaching parity relative to the U.S. dollar. However, now may be the time to start thinking abroad and focusing on diversifying. Canada’s economy is likely due for a slowdown, and evidence is already presenting itself. The housing market has cooled off since the HST was introduced, and the finance minister has tightened mortgage rules to crack down on speculators and discouraged homeowners from taking on too much debt. Some examples of this include stiffer criteria to take out mortgages, tighter restrictions on how much money people can borrow against their homes and higher down payments for speculative investments in real estate. Supply is currently higher than demand with the buyer now having the control, causing prices to start to fall. This will likely continue over the next couple of years with a 10% to 20% decline in prices not out of the question.
In addition, Canada is now starting to feel the effects of the long economic slowdown in the U.S., which accounts for about 70% of our exports. As a result, unemployment should remain relatively high for most of 2011. Moreover, with global recovery not moving as fast as initially expected, demand for our rich commodities might also decline further, dampening prices and causing pressure on the material and energy sectors. However, given the strength of Canadian companies and the strong balance sheets that companies now have globally, acquisitions in Canada are likely to remain high and perhaps provide some support for stock prices.
4. Canadian equities expected to return between 7% and 9%
2011 is expected to be similar to 2010, in that bulls and bears will continue to battle and markets will remain volatile. We should expect a high single-digit Canadian equity market return of 7% to 9% and a low single-digit bond return of 1% to 3%.
5. Loonie grounded while greenback bounces back
Our strong Canadian dollar is also likely to feel some heat in the latter part of 2011 as we start seeing some strength in the U.S. dollar. This is will probably happen as a result of the slowdown in Canada and also because investors will start looking ahead to the U.S. recovery. And if there is any further economy agitation the U.S. dollar will appreciate strongly, as it always does when risk aversion creeps in.
6. Gold stocks will lose their glitter
Gold has been extremely strong over the past few years while economic jitters were high, thoughts of higher inflation were present and the U.S. dollar was weak. However, the economy seems to be moving in the right direction, inflation is virtually non-existent (and will no doubt remain that way for the next few years) and the U.S. dollar appears to have stabilized, with growth expected in the coming years. As a result, the price of gold will likely fall as investors put gold profits into undervalued and higher-growth areas.
7. Equities versus bonds
Equities continue to provide good value, with yields comparable to bonds but with the benefit of potential upside appreciation; valuations remain attractive and the global growth is real. But bonds provide great stability and are an important anchor to a portfolio.
8. The return of dividends
We expect investors’ risk appetites to return and dividends to continue to pay off. Companies still have ample cash on their balance sheets—more than at any other time in history—and it will need to be deployed through acquisitions, share repurchases, dividend increases and/or reinvestment in their businesses. All four of these opportunities are positive for markets and are likely to increase the overall investor sentiment. In Canada, the recent BASEL III report shed more light on how much money capital banks need to keep aside. Based on early indications, this will likely result in companies spending their big cash balances in a combination of the above ways.
9. Modest global growth
Global growth is still real, but the pace is slower than initially expected. Economic stimulus will likely continue (the recent quantitative easing by the U.S. is evidence of this) to support this modest growth, contributing to a slow and steady recovery, which historically has been a good thing for the markets.
10. U.S. versus European markets
The U.S. markets, which have disappointed most people, will show signs of slow growth that will probably increase throughout the year. However, Europe will continue to struggle and lag behind other countries. Moving forward, investors will need to diversify and not focus too much on their home countries. Their appetite for risk will slowly return, and markets will gain traction once expectations become more realistic. Given that the right economic stimulus is in place, a double-dip recession is unlikely.
11. Emerging markets
Global growth over the coming year is expected to be driven by emerging (including frontier) markets. Despite a China slowdown, the overall emerging markets economy is poised to do well relative to most developed countries.
We are in an environment where investors still need to be cautious about the economy and the markets. Even though the recovery is heading in the right direction, the path does not look straight. Portfolios need to be monitored carefully and adjusted as conditions change. Given the expectations of a low-to-moderate return environment in 2011, any additional source of alpha (i.e., asset mix or currency) that can be achieved will have a significant impact. BC
Sadiq S. Adatia is the chief investment officer at Russell Investments Canada Ltd. sadatia@russell.com