Like most of the big banks and research firms Morgan Stanley is pretty optimistic about 2011. Their macro outlook was recently summarized as follows:
“US growth should accelerate, and double-dip and deflation risks are low. In relatively short order, the outlook for the US economy has improved quite significantly. The surprise agreement, when gridlock was expected, to extend the expiring Bush tax cuts and unemployment benefits, along with other fiscal stimulus measures, has raised our US economists 2011 GDP forecast to 3.6% from 2.9%, provided the legislation is passed. They also see a modest uptick in inflation to 2.1%, from 1.7% in 2010. A key pillar in this improving growth outlook is exports. In October, exports surged 3.2% over September, and should contribute 3.2% of the 4.2% GDP growth in 4Q10. Looking forward, the strong growth in EM bodes well for US growth, as it accounts for an increasingly large share of US export, a reflection of global rebalancing.”
Within this bullish argument they’ve provided 5 investment themes for the upcoming year:
“Positive base case, asymmetric downside: Relative to a reasonably positive base case, it’s hard to see the upside to the bull case being much better, given the many structural headwinds that remain in DM and valuations that are not as attractive as they were at the start of 2010. In contrast, the downside is much greater, in our view. The risks are well known: a growth rate in the US hovering around 2-2.5% makes the odds of a double-dip uncomfortably high; sovereign risk contagion to the euro core; and a boom-bust cycle in EM. Failure to address this risks, aside from their obvious negative economic implications, could greatly undermine investor confidence in policy-makers, leading to a sharp correction.
Risk on / risk off investing: We expect this binary sentiment approach to investing to continue into 2011, but it’s likely to dissipate as the recovery, at least in the US, gains traction and tail risks are reduced. In that case, a macro- focused market will give way to more fundamental analysis again. Moreover, with the US growth and EM inflation themes likely to be more intertwined in 2011, assessing whether it’s clearly risk on or off will be harder.
Equities over bonds: The prospect of better growth bodes well for equities, while higher Treasury rates, which our strategists expect, is obviously bad for bonds. The massive inflows into bond funds the past couple of years, and out of equities, could quickly reverse if, for example, the 10Y US Treasury yield rises close to 4%, especially if it’s rapid, putting further upward pressure on yields. The positive growth outlook this scenario entails should, however, be positive for credit spreads. Thus, while bonds may be less attractive than equities generally, those that are the least yield-sensitive can perform well.
EM over DM, but with bumps: The positive secular story in EM — contrasted by the structural problems in DM — and supported by fund flows (both cyclical and secular) continue to make it attractive relative to DM. This is true for equities, whose valuations compare favourably to DM, and EM currencies and sovereign credit, which should both benefit from stronger growth and improving fundamentals. Inflation is the primary risk to EM outperformance. Tightening could be aggressive, especially in China early in the year as it tries to get ahead of the problem. This could lead to a rough 1H11 for EM, allowing DM to pull ahead, followed by a much better second half.
Real over nominal assets: The potential for higher inflation favours real assets and those that are inflation-protected. Commodities are a clear winner — indeed, higher commodity prices are a primary cause of inflation risks. But so too are equities in the commodities complex (energy and materials), and those that have pricing power. We still expect inflation to be tame in DM — our US forecast is 2.1% in 2011 — the prospect of inflation could lead to multiple contraction, as has been the case historically.”
Source: Morgan Stanley
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