“I know what’s around the corner - I just don’t know where the corner is.” (Kevin Keegan)

2010 was a good year for the stock markets, which, for the most part, notched up gains of over 10%. Behind this figure, however, was a great deal of volatility. The US and the European markets were down by 6% at the end of August when Ben Bernanke, US Federal Reserve chairman hinted that the US central bank would engage in a new round of quantitative monetary easing. This announcement prompted a spectacular rally on the markets, which, at the time of writing, is still underway. The current situation seems to confirm the old stock market adage whereby you should never go against the Federal Reserve and that in the short term, liquidity has the upper hand over fundamentals. 

The behaviour of the markets in 2010 is a good illustration of the dilemma currently facing investors. Generally speaking, structural problems persist. More specifically, the increase in public debt, soaring budget deficits and an undercapitalised banking sector will lead to significant problems in the industrialised countries. In the next three years, certain countries such as Japan, Italy and the United States (not to mention Greece, which currently has the advantage of not having to resort to the market for its funding) as well as the European banks will face huge financing requirements.

While the risks seem obvious, the fact is that the authorities, particularly in the US, are willing to do anything to perpetuate the cycle of overconsumption and overindebtedness and to boost the financial markets. Such a situation tends to favour risk-taking, especially in an environment in which the investment horizon is getting shorter and shorter and in a profession where many investments managers have taken Keynes’ advice as their careers guidance: "Never, ever be wrong on your own. You can be wrong in company; that’s okay." They feel obliged to follow short-term movements on the markets for fear of losing clients. Against a backdrop of renewed optimism at the start of 2011 about the economic situation and the ability of European countries to resolve the crisis, this trend is currently resulting in an aggressive sector rotation within the stock markets, with more defensive sectors being sold in favour of financial stocks.

The current rally in risk assets could thus continue for some time. Many observers have pointed out that we have entered the third year of a US presidential cycle, which is traditionally good for equities: since the 1940s, the US stock market has never been down in the third year of a presidential cycle. Moreover, the economic risks that can be detected for the stock markets in 2011 (disappointing company earnings, fears about the sustainability of the economic recovery) seem to be concentrated in the second half of the year.

Our investment strategy will continue to be driven by a fundamental analysis of the economic and financial situation. Based on this analysis, here are our recommendations for 2011.

1. Long-term government bonds

This recommendation goes against the advice of most experts, who believe that the deterioration in public finances and the devaluation of currencies by more or less explicit recourse to the printing press will result in a rise in inflation and push up bond yields, especially in a context of economic recovery.   

I agree that the increase in public debt is very worrying. However, when I speak of buying long-term government bonds, I do not mean that they should be held until maturity, but that they should be kept for around 12 months. An active investment strategy is increasingly as important for bonds as it is for equities.

Why am I recommending bonds now? First of all, the sharp increase in long-term interest rates since September 2010: over the past five months, the 10-year German bond yield has risen by more than 100 basis points, from 2.1% to 3.2%. This means that over the same period, the 10-year German government bond price has lost around 10%. (In the United States, we have seen a similar increase in bond yields, which have risen from 2.4% to 3.5%, leading us to the conclusion that German bond yields are rising for reasons other than just the fear of seeing “Germany having to pay for Greece”.)

Second, the two factors which, in the past, have played a crucial role in determining bond yields are still good for the bond markets. The first is the monetary policy implemented by the central banks and the second is inflation. The Federal Reserve and the European Central Bank will take no risks with the economic recovery and will wait a long time before raising their key interest rates. At the same time, they are doing everything they can to keep down long-term interest rates (over which they have no direct control). In light of this, the significant gap between short and long rates should bolster the bond markets and attract a certain number of ‘natural’ buyers of bonds, such as banks or institutional investors interested in achieving a balance between their assets and long-term liabilities. In terms of the inflation factor, the main component, unit labour costs (wage costs adjusted for productivity gains), is almost non-existent. Finally, I continue to believe that the economic recovery in the industrialised countries is generally artificial, because it is being driven by fiscal and monetary stimulus measures that the authorities will not be able to sustain, and statistical, in light of the significant stock replenishment by companies. Doubts on the sustainability of the recovery, particularly in the United States, could reappear later in the year, in a mirror image of last summer’s events, which prompted the Federal Reserve to engage in a new round of quantitative easing.

Two points should be underlined:

- The price of a long-term bond is highly sensitive to any rise in interest rates. If, contrary to my expectations, long-term rates rise by another 100 basis points between now and the end of the year, an investor holding a 10-year bond will have lost around 5%, including the coupon. The low level of long rates means that any increase in these is felt strongly in the price of a long-dated bond. There is therefore greater risk and volatility involved in investing in these kinds of bonds. In other words, when bond yields are at 3% and rise by 50 basis points to 3.5%, this hurts much more than if rates rose from 7% to 7.5% (what is true in one respect, is obviously also true in the other).

- As I said above and in previous posts, the increase in public debt is a major concern. Some countries are in a vicious circle and will find it difficult to avoid debt restructuring. Investors should therefore focus only on countries with better fundamentals.

>> Investment strategy 2011 - Read on the second part