Equity outlook: Ringing in the new year with an air of uncertainty and overtones of caution

The global equity market is likely to take on a U-shape — for uncertainty — in 2010.

Uncertain corporate profits, fragile global growth rates and concern over how governments will exit from liquidity programs all create big question marks for this year's markets, experts said.

“The strong performance in 2009 was driven by macro factors, higher than expected corporate profits, bargain-level valuation and liquidity. All of those factors created a good cocktail for the marketplace,” said Simona Paravani, global investment strategist for HSBC Global Asset Management based in London. “Going into 2010, liquidity continues to be a plus with interest rates remaining low (in developed markets). But as far as the other three factors are concerned, we are more cautious.”

The biggest unknown on the policy landscape centers on how governments around the world implement exit strategies from the unprecedented liquidity injections, according to several consultants. If policymakers are too early, the fledgling recovery could stop in its tracks. However, too much liquidity for too long could result in runaway inflation.

“We think (policymakers) are very much committed to reflation,” said Tim Drayson, economist at Legal & General Investment Management in London. Governments in developing nations “still fear deflation much more than inflation and that means keeping interest rates exceptionally low right through (2010).”

Another key consideration for markets in 2010 will be the level of economic growth and corporate earnings. “I think that (most economists) have conceded that this will be a below-average recovery considering that it has been such a severe recession,” said Richard B. Hoey, chief economist at BNY Mellon Corp., New York. “However, I do believe firmly that we do have sustainable economic expansion.”

For the rally in global equity markets “to progress from here, it's going to be all about the earnings,” said Richard Mathieson, London-based senior investment strategist in the scientific active equity division at what was formerly Barclays Global Investors, now BlackRock Inc.

While 2009 was marked by “positive surprises” in corporate earnings because of severe cost-cutting measures and low expectations at the beginning of the year, 2010 could potentially have the opposite effect. Pretax profits are estimated to rise around 25% on a global basis in 2010.

“I'm concerned that the possibility for negative surprises to emerge hasn't been factored into the (equity market) rally,” said Carl Hess, global head of investment consulting at Watson Wyatt Worldwide based in New York.

For example, credit is still restricted for small to midsize companies, several consultants said. Unemployment remains a concern, particularly in the U.S., where it is expected to hover around 10% at least through the first half of 2010. “Where's the growth?” Mr. Hess said. “We can talk all we want about building inventory, but if consumption lags, so does the GDP.”

Furthermore, companies are running out of cost-cutting options to boost the bottom line, several consultants and managers said.

“Aggressive cost cutting in Q1, Q2 and even Q3 — especially in the U.S. — has meant that corporate margins have generally been better than anticipated,” said Rekha Sharma, global strategist at JPMorgan Asset Management based in London. “That can only go so far, because companies can't continue to cut cost much more without fundamentally harming their businesses. They need revenue and sales to expand; this will be a key concern going forward.”

The direction of the U.S. dollar in relation to the euro, yen and major emerging market currencies will be a key issue in determining investment inflows on a countrywide or regional basis, said Andrew Milligan, head of global strategy at Standard Life Investments Ltd., Edinburgh. If the dollar rises in relation to the yen and euro, more money could filter into Japan and the eurozone because their securities would be relatively cheaper. However, a rise in the dollar could also depress commodity prices, which would have an adverse effect on certain economies, including certain emerging markets that rely on commodity prices for growth, he added.

The level of macro uncertainties is likely to fuel investors' shift into more diversified, global equity strategies in an effort to quell potential volatility, said Robert Gardner, founder and co-CEO of investment consultant Redington Partners LLP based in London. Furthermore, as institutional investors reassess total portfolio risk management, they are more likely to reduce their overall long-only equity allocation.

“If the answer is less equity, then there would be fewer mandates and therefore broader mandates” covering global equity strategies, Mr. Hess of Watson Wyatt said.

Emerging markets are expected to outpace developed economies in the long run, leading more investors to overweight these regions, Mr. Gardner and other consultants said. However, market imbalances might result in short-term volatility in those regions. The U.S. also appears a favored country to overweight among managers due to continued fiscal support and attractive valuation, while Japan stands to lose out due to weak exports partly because of the declining dollar relative to the yen. Furthermore policy responses from Japan's government are viewed as having been weaker than elsewhere in developed markets, according to several economists.

However, the yen is showing some signs of depreciation, which might favor the nation's exports in 2010. Furthermore, its financial sector is relatively stronger than some of its peers while increasing dividends and share buybacks also might attract investors. “We're neutral on Japan,” Ms. Sharma of JPMorgan said. “We had underweighted Japan for a large part of (2009), but we've moved to a neutral position. Japan could be the best contrarian play out there.”

Aggressive monetary policies in the U.K. have helped to boost the equity market there by 48% as of Dec. 18 from the record low set on March 3, but concerns surrounding unemployment and overleverage might cast a pall over the economy in 2010. Furthermore, political uncertainty — a general election is to be held no later than June 3 — presents a “thorny question” that might negatively affect markets, according to Mr. Milligan of Standard Life.

Economies within the eurozone have experienced severe dispersions. Nations such as France, Germany and the Netherlands fared relatively well throughout the crisis, while Portugal, Italy, Ireland, Greece and Spain — pejoratively referred to as the PIIGS countries — suffer from much weaker economic fundamentals. “We see more downside than upside risks” in the eurozone, according to HSBC's Ms. Paravani.

On a sector basis, the financial industry still causes the most concern because of “the major governments' plans to regulate the financial sector, particularly the banks,” according to John Velis, head of capital markets research for Europe, Middle East and Africa at Russell Investments based in London. Ishares Standard & Poor's Global Financials Index Fund, for example, more than doubled to $45.56 per share in the nine months since its nadir on March 9, when shares closed at $19.15.

“This is a stunning comeback by the sector,” Mr. Velis said. “We don't know how (financial companies) will be regulated, how much leverage they will be able to take on, how (governments) plan to wind down aid programs, or even how banks will make money in the next decade.”

The level of uncertainty means more divergence both at the country level and individual company level, which should create more opportunities for active players, several managers said.

“We're cautiously optimistic,” said Arlene Rockefeller, executive vice president and global equities CIO at State Street Global Advisors, Boston. “We're not looking for the highest beta stocks. We're looking at stocks that do well in their own particularly sector or country, stocks with strong earnings characteristics but don't look like they're overpriced.”

As the global economy moves toward recovery, “companies that tend to do well during this phase of the (economic) cycle include those that might potentially be a good merger or takeover target.” Quality companies with sustainable or increased earnings potential, good cash flow and quality balance sheets will become more attractive in 2010, Ms. Rockefeller said. Other stocks that may become more attractive in 2010 are those within “sectors in which people have delayed investments, such as technology.”

“The strongest companies will be the ones that do the best,” particularly in the U.S. market, she added.