Market Review of 2010

At the beginning of each calendar year, Blackstone vice chairman Byron Wien publishes a list of ‘10 Surprises’ for the financial markets. Wien started this tradition during his days as chief strategist at Morgan Stanley.

During several luncheons held in New York in the past, Wien was fond of explaining the cultural barriers that he had to overcome at Morgan Stanley, in order to launch the 10 Surprises series. Surprises are, by definition, surprises, but Wall Street has been listening to Wien because his predictions have enjoyed a credible track record.

The 10 Surprises did not do so well this year, however. This article will summarise what Wien predicted, as well as how the world has turned out in the final weeks of 2010. We also want to better understand if there are any fundamental changes to the world, that led to the less-than-stellar performance of his 10 Surprises in 2010.

The following is a summary of Wien’s 10 Surprises in 2010:

  1. Key financial market indicators: The US economy resumed growth. US unemployment rate started dropping. The Fed funds rate began moving away from its near-zero range. The yield on 10-year US Treasury bonds moved above 5.5%. Foreign central banks began to show reluctance in buying US treasuries. The S&P500 Index rallied and then receded. The US dollar strengthened.
  2. Obama administration: The improvement in the US economy energised the Obama administration. Mid-term election results, while unimpressive, fell short of causing embarrassment to the Democrats. The Obama administration would be able to push through an energy policy agenda. Financial services legislation, such as the health care bill, passed with some positive outcomes.
  3. Driver of global recovery: Japan stood out as the best performing major industrialised market in the world as its currency weakened and its exports improved. The Nikkei 225 rose above 12,000.
  4. Global hotspot: Civil unrest in Iran reached a crescendo. Pakistan became a hotspot in the region because of weak government.
  5. Across the Atlantic: There was no specific mention of Europe in the 10 Surprises of 2010.

With the benefits of hindsight, the real surprises in 2010 turn out to be the following:

  1. Key financial market indicators: The US economy continues to stagnate. US unemployment stays at historical levels. The Fed funds rate is still in its near-zero range, with the Fed having to resort to another round of quantitative easing (QE2). The yield on the 10-year US treasury has been hovering above 3% for most of the year. Yet, there is no obvious sign that foreign central banks have other credible alternatives besides buying US treasuries. The S&P500 Index trades between 1050 and 1250, but is now near its year-to-date high. The DXY, the US dollar currency index, has been trading in a range around 80 for most of the year.
  2. Obama administration: The Obama administration is clearly losing momentum in its policy agenda. It suffered from a disastrous mid-term election, while Obama’s own approval rating is now slipping to the mid-40s. Surprisingly, the administration even failed to leverage the worst environmental disaster in US history to push through a meaningful climate or energy policy agenda. While the Dodd-Frank banking reform legislation was finally passed, there are plenty of noises questioning the competency of those responsible for its implementation. In the meantime, other countries are also beginning to question US leadership in the G20 process for global financial regulatory reforms.
  3. Driver of global recovery: Instead of Japan, China is now the champion of global growth. China is proceeding with the initial stages of internationalising the renminbi (RMB) while allowing limited flexibility in its exchange rate policy. It is also increasingly assertive in its foreign policy. By contrast, the Japanese economy continues to stagnate, with the Nikkei 225 staying roughly flat for the year.
  4. Global hotspot: Instead of Iran or other well-known hot spots in the Middle East or central Asia, the Korean peninsula is now the world’s most dangerous flashpoint. At the same time, Japan’s defense policy focus is shifting south.
  5. Across the Atlantic: While a few hedge fund managers began questioning the viability of the euro several years ago, the market in general was caught by surprise by the euro and sovereign debt saga.

To be fair, making predictions is a far more hazardous business than commenting on such predictions with the benefit of hindsight. Nonetheless, it may still be useful to understand the dynamics explaining why many of the 10 Surprises of 2010 failed to materialise:

  1. Fundamental economic problems in the US: In short, the US is spending too much while not producing or investing enough, especially on longer-term investments such as education and infrastructure. For now, ‘printing money’ is used to sustain a consumption-driven economic growth strategy. The real surprise here is that foreign central banks continue to buy large amounts of US treasuries. Despite talks of reserve diversification, foreign central banks have no obvious alternatives besides gold, but the continuous rise in gold prices also makes it a risky alternative. That is not to say that one should write off the US economy despite all its well-known problems. Its venture capital culture, research and development (R&D) innovation and the Silicon Valley are still the envies of the world. However, it is also true that the country’s economic engine is increasingly driven by its well-educated, foreign-born citizens, who are ready for a much higher degree of global mobility than their US-born counterparts. Accordingly, it will be increasingly difficult for the US to implement policies that assume some degree of economic hegemony.
  2. Dysfunctional nature of the US political system on economic issues: The US political system, almost by nature, tends to avoid making tough but necessary decisions on economic issues, because of their potential unpopularity in elections. At the same time, populist policy implementation with even the slightest hint of egalitarianism often creates more problems than it solves in today’s global financial markets. It is not yet obvious that the financial reform legislations are achieving meaningful positive impacts. Likewise, the consensus-driven nature of the G20 process is increasingly dysfunctional: G20 will only work under a credible leader. Unless the US puts its own house in order, other countries may not be inclined to listen to its preaching.
  3. China driving global recovery: Judging by the number of China-related headlines appearing on the front pages of the Financial Times this year alone, one will be forgiven to suggest that we are already in the era of the G2. On a purchasing power parity basis, a further appreciation of RMB by 30% to 40% upon its full convertibility is not entirely out of the question. In short, the real economic strength of China is still understated by published statistics. The high savings rate in China is a cultural artifact that will not be changed overnight. Eventually, full convertibility of the RMB may be the only real solution to global payment imbalances and excessive domestic speculations, in terms of offering the Chinese population alternative ways to park their savings. While China is still a long way from Japan in terms of its per capita gross domestic product (GDP), it will close the gap gradually, as the latter is undergoing a significant demographic transformation.
  4. Korean peninsula as the world’s most dangerous flashpoint: Kim Jong-Il may not be as delusional as he likes the rest of the world to believe: he too may harbour insecurity that his battle-hardened generals may not be too keen to listen to his 28-year-old, Swiss-educated son who was recently made a four-star general. China is now caught between a rock and a hard place. If the North Korean regime collapses, the flood of refugees and a possible takeover by the South Koreans may mean American troops on its doorstep. In short, China does not want to lose North Korea as a geopolitical buffer zone. Therefore, a Chinese takeover should not be written off completely, in the event that the North Korean regime does implode – after all, no North Korea general can ignore the simple fact the country depends on China for most of its energy and food supplies. The pragmatic foreign policy question is whether China can handle the situation with sufficient finesse that the final solution will look palatable to the rest of the world, especially to China’s important allies and neighbours in east and central Asia.
  5. Problems in Europe unlikely to be resolved overnight: Greece is often called the tip of Europe’s iceberg. There is no lack of estimates available on the amount of recapitalisation required to ‘fix’ various financial problems among the many nations caught up in the sovereign debt crisis. The fundamental issue is that the euro imposes a uniform set of monetary policies on a collection of countries with wildly different economic conditions. A similar scenario existed in the US for parts of the 20th Century, but it worked out because there is only one single US federal government, which can make certain economic adjustments by differential fiscal spending. On the other hand, the inability to sustain differential fiscal spending among EU countries has precipitated the sovereign debt crisis.

One key underlying theme is that these drivers fall under ‘extreme scenarios’ that are setting new paradigms in the global economy. Whenever no comparable historical data or scenarios are available, inferring the future from the past may suffer from significant ‘model calibration bias’. That’s probably why even a successful forecaster like Wien did not do quite as well in 2010 as he had done in the past.

An alternative approach is to develop a structural description that fits the dynamics of the global economy. This kind of war game approach can then be used to derive possible ‘unknown-unknown’ scenarios (in the famous words of Donald Rumsfeld). Certain central banks and supranational organisations are known to deploy such expensive techniques to study significant policy questions, such as the possible alternatives to the euro and the eventual convertibility of the RMB. Needless to say, most of us won’t have access to such sophisticated models and their insights.

Conclusion

So what is the moral of the story to the savvy finance professionals of 2011? This has been the first year in which decoupling is no longer a debate, and when there is clear evidence in the markets suggesting that the global economy is going through some rapid and probably fundamental transformations. Predicting market behaviour may be extremely arduous even for a seasoned maestro. Under these circumstances, a healthy dose of common sense and scepticism, along with some back-to-basics reasoning, may be far more trustworthy as a guide to the 2011 markets than any heavy reliance on models and historical data.

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