Investment Outlook – New Year 2010

Economic recovery is well underway, as the necessary preconditions for a sustained rebound appear to have fallen into place. Epic doses of monetary and fiscal stimulus have yet to show their full impact on the economy and will remain as a factor supporting markets for several more quarters. Despite the impressive move in equity and credit markets since March, memories of the crisis remain fresh and many investors are maintaining a very cautious stance. Equity market valuations remain unusually attractive. The window of opportunity remains open as the global economy continues on a path to normalcy, and we have notched our exposure to stocks slightly higher.

Outlook Hinges on Self-Sustaining Recovery

The deepest U.S. recession since the Great Depression came to an end sometime this past spring or early summer. New sources of economic growth are surfacing. Home prices are no longer falling, and both buyers and builders are re-emerging. While we are uncomfortable with the sheer volume of homes moving through the foreclosure pipeline, the fact remains that the root of the credit crisis – the bust in housing – is finally stabilizing. Inventory re-stocking is another potential source of growth in the coming quarters. As companies see the economy stabilize and sales pick up, they will have less and less motivation to pare inventories.

The main economic question is how close the U.S. is to a self-sustaining recovery. In our view, even in the absence of government support, the likelihood of the economy falling back into recession is low given the building and broadening momentum in the sources of growth. Despite this relatively optimistic longer-term outlook, some key conditions for a self-sustaining recovery remain somewhat elusive. In particular, the U.S. job market remains weak, and credit availability continues to be severely constrained for all but the largest and most creditworthy borrowers. Additionally, there are broader concerns about the ability of authorities - and timing of their efforts - to reduce support for the economy without tipping it back into recession. Finally, the ballooning debt burden casts a dark shadow over the future potential of the U.S. economy and for many major industrialized nations in Europe and Asia.

Inflation remains low and contained. There are, however, several signs that suggest today's benign inflation environment may not last beyond 2010, and these need to be closely monitored as the economy moves into expansion.

Short-Term Weakness, But Dollar Should Find Support in Medium Term

The U.S. dollar has continued to grind lower as dollar-bearish stories dominate the media. The list of negative arguments is long and well disseminated, with the market positioned for further dollar weakness. While sheer momentum may push the greenback lower in the short term, valuations suggest that it should find some support in the medium term. Currencies will be very sensitive to shifting expectations for interest rates in 2010. Fed hikes should support the U.S. dollar in particular.

Expect Short Rates to Remain at Record Lows for Now

Given the fragility of the recovery, central banks are widely expected to hold short-term interest rates at rock-bottom levels for at least the next six months in North America. We look for the first, minor rate hikes to begin in mid-2010, but the bulk of the move in global short rates above current levels remains a 2011 story.

Expect Long-Bond Yields to Drift Higher

As the threat to the financial system dissipates and economic growth is gradually restored, we expect bond yields to move higher. A rise in inflation expectations and the demand for "real" returns present a risk to fixed-income markets and set the stage for very limited total-return prospects for government bonds in the quarters ahead.

Equity Valuations Remain Attractive

Equity markets have spent the past eight months in one of the strongest and most impressive rallies since the 1930s. Unfortunately, many investors have stayed on the sidelines, waiting for an appropriately sized correction as an entry point, only to watch markets climb inexorably higher. While we recognize the risk of correction, we are increasing our overweight in equities for two key reasons. First, while earnings have already rebounded sharply on aggressive cost-cutting, they do not yet reflect the increase in sales volumes that we think will occur with the improving economy. Second, U.S. stock market indices and those of most of the developed world remain very attractively valued and are close to their greatest discount to fair value in a half-century.

Increase Overweight in Equities, Lower Cash

We have increased our overweight in equities, sourcing the funds from cash and leaving fixed income exposure unchanged. This reflects our view that market and economic signals are still pointing to greater rewards from equities, given attractive valuations relative to other asset classes. We remain underweight bonds versus the benchmark, as we believe that the most likely longer-term direction for yields is higher, while near-term total return prospects seem limited.

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