2010 was the year of recovery for many markets affected by the global crisis. For 2011, it appears that moving forward may still be tough for certain asset classes. Deutsche Bank PWM's Christian Nolting writes his forecasts.

Summary: 2010 was the year of recovery for many markets affected by the global crisis. For 2011, it appears that moving forward may still be tough for certain asset classes. Deutsche Bank PWM's Christian Nolting writes his forecasts.

2010 was a year characterised by market volatility and high sensitivity to macroeconomic events, as the global economy underwent several economic headwinds. Macroeconomic events dominated the markets, such as the implementation of quantitative easing (QE2) measures by the US Federal Reserve, the sovereign debt crisis in the eurozone, as well as shifts towards policy tightening in the Asian economies. However, it is important to note that it is normal for markets to fluctuate up and down and experience high volatility.

Equity returns in recent years have become more bi-modal, with more frequent instances of extreme returns. Although volatility remained in the global markets in 2010, equities such as emerging markets (EM) stocks also continued their uptrend during the year, presenting numerous investment opportunities for investors. Dynamic asset allocation and the right use of “portfolio buffers” therefore became increasingly important in portfolio management in 2010.

Asset classes that did well in 2010

For fixed income (sovereigns), EM sovereign bonds and US treasuries were the best performers, with the sectors gaining 13.03 per cent (according to Markit iBoxx Global Emerging Markets Local Currency Bond Index, in USD) and 5.82 per cent (according to iBoxx USD Treasuries Total Return Index, in USD) respectively in 2010. For fixed income (credit), investment grade corporate bonds returned 9.37 per cent in 2010 (according to iBoxx Liquid Investment Grade Index, in USD). Within the equity space, EM equities were the clear winners, with EM Asia ex-Japan the best performing region. In 2010, the MSCI Emerging Market Index gained 16.36 per cent (in USD), while the MSCI Asia Pacific ex-Japan Index gained 14.97 per cent (in USD).

With the exception of China and Hong Kong, most Asia ex-Japan equity bourses managed to register impressive double-digit returns. US equities initially struggled for the first half of 2010 before rebounding strongly from the third quarter onwards, posting a positive return of 12.78 per cent as at year-end 2010. Commodities outperformed other asset classes in 2010, posting a positive 17.40 per cent return (according to the Thomson Reuters/Jeffries CRB index).

After a dismal start, commodities recovered strongly in the last quarter of 2010, owing to the liquidity-driven rally following the implementation of QE2 by the US Fed, and also tightening in the physical fundamentals. Precious metals and agriculture were the engine rooms of performance in 2010. For instance, gold appreciated by 29.52 per cent while silver appreciated by more than 80 per cent during the year. (Data source: Bloomberg Financial LP).

Did 2010 play out as predicted?

We are happy that 2010 played out well and, to a large extent, very close to our house view. For example, we had earlier predicted that in 2010 markets would likely face several economic headwinds, volatility would remain high and downside risks would remain elevated, as the global economic recovery began to progress broadly. This had guided us to position our clients’ portfolios well in advance to ride out the market volatility.

2010 versus 2011

We think that several economic trends that emerged in 2010 will continue to develop in 2011. Firstly, the emerging trend of a bi-polar world where emerging markets deliver structurally stronger economic growth prospects than developed markets should continue in 2011.

In addition, we should continue to see increasing divergence between economic growth, not just between the emerging and developed markets, but also within regions such as the eurozone and Asia. Secondly, we expect emerging markets to continue to outperform the developed markets in 2011, albeit by a smaller margin (as US and European markets are likely to also report positive returns) and back-end loaded to the second half of 2011 (near-term pressures for emerging markets should persist on fears of tightening due to inflation pressures). However, market volatility could also stay elevated in 2011.

Although global growth seems to be well underpinned now, there are still numerous key issues to be resolved. For example, uncertainties continue to loom over the eurozone. What is important is for markets to regain confidence in the region while the European Central Bank and governments try to resolve the underlying issues.

There are also some key differences we could see play out in 2011. Firstly, while markets in 2010 were somewhat macro-driven, we think this trend could reverse in 2011, meaning fundamentals could play a more important role. Secondly, given that the US economy has lately been showing increasing signs of a recovery and looks to be in a better shape going into 2011 as compared to the start of 2010, 2011 could be an interesting year for equities. Deflationary fears in the US should also slowly transition towards positive inflation expectations this year.

Potential risks that investors should look out for in 2011 include uncertainty over the timing and speed of monetary policy exit and fiscal policy decisions, as well as the outlook on the budget deficits and debts of the G7 economies.

Investment themes for 2011

We believe 2011 could be an exciting year for the markets. Several investment themes that investors could look at include:

1. Spreads as some cushion for a rising interest rate environment:

The hunt for yield is expected to continue in 2011. Within bonds, we prefer investment-grade corporate bonds and emerging markets sovereign bonds over developed markets sovereign bonds, given the constructive outlook in 2011 for risky assets. Robust corporate balance sheets have also been supportive of credit spreads.

2. High-dividend equities:

High-dividend equities are an attractive alternative to bonds for income-focused investors. In the US, many companies in the S&P 500 are currently paying an attractive dividend in excess of their intermediate corporate bond yields after tax. Industry sectors that typically yield high dividends include telecommunications, utilities, energy and materials.

3. Own equities in emerging markets:

We think that EM stock markets are not overbought yet. Despite the robust outperformance of EM stock markets, the estimated share of EM stock market capitalisation held by EM funds has recovered but is still falling short of the 2002-2007 average levels.

4. Also own developed market equities:

The continuing earnings recovery is the main driver of stock market performance. Valuations are compelling as current price-to-earnings ratios are still significantly below their median levels (2002 – 2010). In addition, the continued recovery of the world economy and accommodative monetary conditions in DMs should likely be supportive of equity market performance.

5. European stocks with BRICs (Brazil, Russia, India, China) exposure:

BRIC-exposed stocks remain attractive based on their earnings outlook and relative valuations. Relative to European companies that derive their revenue mainly from the Europe region, European companies with BRIC exposure offer higher margins, higher EPS growth potential, and are trading at a larger valuation discount.

6. Emerging markets currencies:

Fundamental reasons for currency appreciation for emerging markets remain strong, given their stronger growth and return outlook, robust fiscal position, higher interest rates and strong capital inflows owing to high liquidity (zero interest rate policy in G3). Particularly for Asian countries, currency appreciation pressure stems from their high current account surpluses (trade-related inflows), which are likely to persist.

Although some Asian central banks introduced capital control measures in 2010 to stem the inflow of foreign capital and limit their currencies from appreciating too aggressively, we think that it is unlikely to be effective. The more effective way we think is for the Asian economies to re-balance towards consumption, which is already well under way but takes time. Hence, we remain positive on emerging market currencies. Investors could gain access to these currencies through local market bonds.

7. Commodity super-cycle still in place:

In 2011, we could see a shift from heavy (metals, energy) to intellectual infrastructure (software, services, food) as countries such as China adjust their industry and economic structure. According to China’s latest "Five-Year Plan", some of the focuses of the Chinese authorities over the next five years include promoting manufacturing upgrade (which bodes well for machinery, equipment and new energy sectors), accelerating modern agriculture, and the growth of the services industry. Rising incomes and standards of living in Asian countries should also boost the demand for food consumption, which in turn bodes well for soft commodities/agriculture.