An outlook for world investment markets in 2011 and the key macro themes.

1. Investment Markets in 2011
The key investment market trends of the year will be symptomatic of the
underlying macro position and changes in the global economy as well as a
shift in the positioning of investors as a response to stronger US growth.
Macro
1. Two-speed global economy
The rapid growth in the BRIC economies and the emerging world will continue
with China acting as an engine of growth and the largest source of new
demand for commodities. Growth pains will be felt, in particular in China, with
inflationary pressures a key metric. The recent interest rate lending hike of
.25% to 5.81% before Christmas whilst the rest of the world was distracted
demonstrates that inflation is being carefully monitored.
These growth pains will continue to be addressed through government policy
which is aware of the need to develop stronger internal markets, consumer
spending and local development as a gradual shift away from the export led
economic model that has been so successful since 1978. RMB devaluation
will continue – at a snails pace - and will be a continued talking point as part
of the ʻcurrency warsʼ paradigm.
In contrast, developed world economies in Europe and the US will find some
stability post-crisis but with high levels of unemployment, public sector budget
cuts and low levels of inflation from spare capacity. The US will have a good
year with stronger growth than 2011 and will cause a re-positioning of
investors. The UK will likely under-perform as a result of ʻfront loadedʼ
spending cuts in 2011 so that the coalition government has 4 years in office if
it goes wrong.
The global imbalance of spenders and savers through the trade balance will
persist and will do so for the next 5-10 years. This will present additional
challenges to developed world economies (US, Europe) in reducing trade and
budget deficits and to developing countries in stimulating domestic
consumption.
2. Demand-led commodity price rally
(...with isolated supply shocks)
The rapid growth of EM and large BRIC economies in particular will feed the
commodity price rally in 2011. This, coupled with continued supply shocks in
certain markets (cereals, oil, iron ore) will see continued price rises for key
commodities. However, this will be during a year of greater price volatility than
in 2011 with Gold prices at risk in particular as investors shift away from
hedges given stronger US growth.

2. However, dollar weakness and concerns over the expansion of the global
monetary base should see metals (gold, silver and bronze) continue to
appreciate, but by less than in 2010.
Whilst the global demand for commodities is unbalanced, the global price is
the same. To this end, the developed world economies will have to pay higher
oil and cereal prices as a result of the rising demand in the developing world.
This is one of the biggest global risks of the year.
Rising commodity prices will generate inflationary pressure and has the
potential to create a stag-flationary environment. However, given that there is
some 25% spare capacity in European economies in particular from 2007
levels, this may be contained. The policy response of changing interest rates
would be contained by fears of raising interest rates at a time of fragile
economic stability – leaving policy makers with a dilemma as to how to
manage the risk.
3. Developed world de-leveraging
(...and developing world leveraging)
Developed World Deleveraging
De-leveraging at the household, corporate and sovereign level coupled with
high unemployment will continue to sap aggregate demand in the developed
world which will in turn hold back economic growth below trend. However,
growth will be stronger in the US than in 2010 which will cause investors to
reposition their portfolios across the year. Last yearʼs rally in fixed income
treasuries (high point in August) and commodities were partly driven by
hedges against weaker US growth and volatile equity markets.
This will partly unwind in 2011.
The bond market will continue to attack those economies that have weak
fiscal positions relative to peers with Portugal and Spain to be tested in Q1
2011. The effect of austerity measures in European economies will start to be
seen in 2011 with key tests for GDP in Q1 and Q2. We will know the results of
these tests in April and July respectively with higher market volatility across
asset classes around these dates. If growth starts to weaken markedly, 0.25%
change or higher, markets will enter a period of higher volatility.
The potential for further financial shocks within the banking system should
also be monitored carefully as a result of continued deleveraging. Various
government support mechanisms will be withdrawn in the UK and Europe in
2011 that will see banks forced to seek new sources of liquidity. The maturity
cliff in 2011 and 2012 will see banks have to manage their exposures to
commercial real estate (CRE).

3. The UK market has some £38bn maturing against CRE assets in 2011 alone
with a global funding gap of around $245bn between 2011 and 2013
according to DTZ. In addition, corporate loans and LBO loans to PE
borrowers are maturing from 2006 and 2007 vintage.
As a result of these legacy exposures and the withdrawal of liquidity facilities
and other support mechanisms from 2008/9, lending to both households and
corporates in the developed world will remain subdued.
To a large degree, a lot of the so-called 'new lending' is actually refinancing of
outstanding loans to existing borrowers through 'new' loans. This enables
banks to project their ʻwillingnessʼ to lend whilst keeping troubled loans on life
support, claiming higher interest rate margins in the process and not
extending credit to new, higher risk borrowers (which is good for their bottom
line).
Watch the US municipal bond market. US states are struggling (California,
Illinois in particular) with both state deficits and public pensions that are
running out. Meredith Whitney believes there may be 50-100 Muni defaults in
2011 which will further strain US finances and will help the kick-out of US
yields.
Developing World Leveraging
2011 will see the continued use of leverage and credit expansion in the
developing world and in the BRIC economies in particular. Mindful central
banks are already imposing restrictions and capital controls to prevent over-
heating (China, Thailand).
This will be closely monitored by central banks but is a necessary part of the
development of consumer spending and the consumer class. Inevitably, credit
markets will either expand too quickly or too slowly which will provide shocks
but these will most likely be seen in 2012 and beyond rather than in 2011.
Investment Markets
The global macro position will feed the performance of various investment
classes in 2011. The strongest trends will be;
1. Rising commodity prices (cereals, oil, metals), with higher volatility
2. Emerging market outperformance (equities will beat fixed income)
3. Weakening of developed sovereign fixed income markets (US, Eurozone)
4. Use of covered bond market by banks as new source of liquidity
5. US equity market rally as the little guy returns
6. Shocks in the US muni market

4. Investment Capital will be attracted to;
1. Emerging markets (equities in particular after success in fixed income)
2. Commodities and commodity producers
3. Technology (ʻnew techʼ beating ʻold techʼ hard, soft, web)
4. Real assets (real estate, manufacturing) as positioning for inflation
Investment Theme
Performing classes will be based on the macro trends but also represent real
change, real development of markets, real output of products and real
development of tangible technologies.
This is in contrast to the largely superficial credit driven prism of development
and change from 2002 to 2007. This therefore represents a desire from the
market to acquire real assets or have exposure to real development.
2011 Winners
Equities Winners:
EM, Mining, Metals, Energy, Tech, Security, Telecoms
EM economies should continue to post 5%+ growth rates in 2011 and will be
the major source of global growth. As a result, the stock markets of EM will do
well as investors continue to buy into the growth as part of a re-weighting of
western portfolios. 2010 saw EM fixed income indices perform around 13%,
building on this success, portfolio managers will increasingly weight towards
equities.
Mining, metals and energy stocks will do well broadly as a category on the
basis of continued and rising demand from the BRIC countries. Of course, the
sector will see individual winners and losers – note continued recovery in BP
shares.
Technology and telecoms will do well as categories because there is real
innovation that is rewriting many of the old rules of IT. We used to talk of 'old'
economy and 'new' economy companies. Now, I believe we can talk of 'old'
and 'new' tech companies. Old tech companies would be Dell, Microsoft,
Cisco, AT&T whilst new tech companies would be twitter, RIM, Facebook,
Apple. Note the recent implied $50bn valuation of Facebook after Goldmanʼs
$500ml investment, this is double the implied valuation from summer 2010.
Needless to say, new tech companies can be defined as those who specialise
in wireless, device based technologies that offer users the ability to connect to
social networking sites as well as communicating on the move. As such, data
services, transmission and storage will do well.

5. The old tech companies are those who offer users mainly fixed location (pc
based) IT services from software to hardware. For instance, in 2010, shares in
HMV fell by 70% as they failed to adapt their business model quickly enough
to online based services. As a result, new tech company equities will do well
at the expense of old tech in 2011.
Commodity Winners:
Cereals (wheat, soy), crude and metals (gold, silver) Iron ore, copper, bronze
Cereals will further rise in price in 2011 driven by supply shocks as well as
rising demand from developing Asia. Similarly, China, India and Brazil are
thirsty with their annual demand for crude oil increasing faster than the
possible rate of production. This will see further pressure on oil prices to
above $100 per barrel and probably between $100-120.
Gold and silver will continue to do well as investors continue to price the risk
of inflation after the large monetary expansion of the last few years. QE2 has
helped drive gold higher (and all markets) and it will be the safe haven of
choice during any market shocks during the year. Whilst the market may
worry that gold has had a good rally over the past 18 months, investors will
also invest in silver.
Iron ore is necessary for steel production which will also have a good year in
2011 as the US economy has a stronger year than in 2010. Also, continued
demand from developing EM markets will feed demand for this, copper and
bronze. Whilst copper is at multi-decade highs, it probably has further to run.
Fixed Income Winners:
EM, Covered Bonds, E-bonds
Whilst EM credit has performed exceptionally over the past 18 months as an
asset class (EMBIG index) investor appetite for exposure to the developing
world will continue to grow in 2011. Performance may be 7-9%, in contrast to
13% in 2010.
Portfolio managers will continue to increase their investment allocation
towards this asset class. The average US pension fund (the US has about
80% of the world's investable capital) has about .5% invested in EM. The
potential for increase is huge.
Covered bonds will have a fantastic year and beyond as it will be the
instrument of choice to commercial and investment banks which will continue
to rebuild their balance sheets and de-lever. The debt security is popular with
investors because it offers a rated position against real bank balance sheet
assets, including in bankruptcy.

6. This is opposed to securitisation, which is typically 'off balance sheet' and
does not offer investors recourse to issuing bank assets.
The launch of 'e-bonds' by the EU via the European stability fund and other
newly created institutions will be popular with global investors, especially
sovereign wealth fund from the ME and Asia.
The bonds offer a 100-200 basis point (1%-2%) spread to German bunds
(German government issued bonds) and are guaranteed by the EU.
Currency Winners:
RMB, RUB, Euro, JPY
2011 Losers
Equities:
Consumer goods, Banks, Durable goods
One of the likely losers in 2011 will be consumer goods equities (UK, Europe)
as austerity measures squeeze household wallets. Financial services are at
risk from banking system shocks (liquidity, refinancing) as well as regulatory
restrictions that will squeeze some profit centres.
Fixed Income:
Gilts (US, UK, Eurozone)
Investors will continue to attack weaker fiscal economies in the Eurozone as
well as unwind their hedge against lower US growth. As a result, treasury
yields in the US will rise. UK gilt yields will also be at risk given the potential
negative effect of austerity on UK GDP.
Currencies:
USD, GBP
Dollar weakness as a result of increasing money supply and an unwind of
treasury buying and lower GBP as a result of potentially less UK GDP growth.