Ten Predictions for 2011

In this feature, Ted Scott, Director, UK Strategy, at F&C takes a “big picture” look at the year ahead and provides you with ten economic predications for 2011.

1. Euro weakness set to continue
The strength of the Euro towards the end of 2010 came despite further deterioration in the sovereign debt worries, with Ireland seeking financial assistance from the EU and IMF. I expect the European economy to slow and the Euro strength in the second and third quarters of 2010 will have been a hindrance to Germany, which dominates the Eurozone. Markets have been focused on the US dollar and Quantitative Easing (QE) and the Euro has strengthened by default. The bailout of Ireland, and possibly others, is likely to undermine confidence in a similar way as it did in response to Greece’s sovereign debt issues and there is a real possibility that private creditors will suffer.

2. De-Equitisation in the UK equity market
We are likely to see an increase in merger and acquisition activity (M&A), share buy-backs and dividend payments. This theme is positive for equities as a whole and is likely to remain in place while companies can achieve higher returns by investing in their own shares or those of other companies rather than investing to increase their own productive capacity or retain capital as cash. Companies’ balance sheets are relatively strong and the dividend payout ratio is lower than it normally is.

3. Stocks with a high yield to flourish as there is an increasing scramble for income
This means companies that have the capacity to pay higher dividends if they want to and are already beginning to do so are set to be favoured by investors. In a low yield environment where highly rated debt (government or corporate) has historically low yields, there is an opportunity cost in holding it. Already the scramble for yield has been seen in emerging market currencies where interest rates are higher and it is beginning to be seen in equities. However, it is important that the yield is secure and preferably rising.

4. US 10 year Treasury bond to continue to fall
I don’t believe that QE will succeed in stoking up inflation and, on the contrary, think that core inflation will remain too low for the US Federal Reserve’s (Fed) liking for some time. QE is not working because of a lack of demand for credit, as well as a reluctance to extend it to the private sector and especially to smaller companies and individuals. Therefore, with the housing market still weak and unemployment high it is likely that bond yields will drift lower as the Fed purchases them as part of its QE programme. Remember that this further increases the attraction of equities with safe yields.

5. Gold set to remain an attractive investment
The metal had a wonderful run in the second half of 2010, partly in response to the weakness of the dollar and to QE, and is likely to see a period of consolidation, as it had in the first half of 2010 following a similar surge late in 2009. The reasons for being positive on gold remain intact: it is an excellent each way bet where low risk assets are yielding nothing or very little (i.e. there is little opportunity cost in holding it). Meanwhile, the imposing risks that remain in the financial world add to its lustre. Until the global economy is on an even keel, gold will remain a safe haven.

6. Further extension of QE by the Fed
I do not believe that QE2 will succeed in creating the extra growth and employment that the Fed is aiming for as explained above. Also, with inflation likely to remain below the Fed’s target it means that, when the purchase of $600bn expires in June, I expect the Fed to authorise another tranche. I do not think that the Fed will change tack and if new policy measures are introduced, such as an inflation target, they will be in addition to QE rather than a replacement.

7. Larger companies to outperform smaller
The FTSE 100 Index is top heavy and dominated by the half dozen or so ‘mega’ caps at the top, along with the resources sector. Although the miners did well in 2010, after a poor first half, the large companies as a group underperformed because of BP and the drab performance of GlaxoSmithKline and HSBC. I still think resources stocks will do well next year and it is a huge sector now, despite being vulnerable to profit taking in the short-term. Also, Vodafone is still attractive and the rating of GSK is so low it has found a floor. HSBC has had upgrades and is no longer on the stretched valuation that it was in early 2010. Obviously, the prospect of M&A is reduced amongst the larger companies, but another advantage is the overseas and especially emerging market, exposure. The smaller companies are more domestic and the cyclical shares are predominantly industrial where valuations are demanding.

8. The market is likely to peak in the first half of 2011
The run of the market in the latter months of 2010 took it to new highs post the collapse of Lehman Brothers and is positive from a technical view as it has broken out of a narrow trading range. With the 30-week moving average rising, any consolidation will represent a short term buying opportunity, ceteris paribus. Fundamentally, modest valuations and liquidity from QE are providing the rationale for the rise in equities but as it becomes apparent that the financial problems in developed markets are still present, especially if QE proves ineffective, equities may retreat. A further round of QE would then be treated with a lot more scepticism.

9. Trade and Currency wars to intensify
The stand off between the US and China worsened towards the end of 2010 following the advent of QE2. The ramifications of this are likely to be seen in 2011 as both nations remain intransigent in their policies. However, the need for an emergency coordinated policy response has largely passed now that economies have or are recovering. Therefore, competitive devaluations and, perhaps more dangerously, tariffs look set to follow.

10. The Euro zone debt crisis to escalate further
The pick-up in bond yields towards the end of 2010 is a reminder that the late summer lull was just that. Ireland has joined Greece on the intensive care list and the market’s attention is now moving on to Portugal, the next weakest economy. But the EU authorities, true to form, are closing their ears and eyes to what the markets are telling them. The fact that Ireland needed to seek aid and the likelihood that the government may fall as a result, could trigger further contagion in the other weaker economies. One should not overlook Italy, which has one of the highest debt to GDP ratios and, like Spain, is too big to fail.