Global Markets Weekly

20 December 2010

• Seasonal cheer and an improving economic environment boost equities in December
  
  Developed-market equities have risen 5% so far in December, while emerging equities are up 2% in local currency terms and 3% in dollar terms as their currencies continue to strengthen. While US equities have fallen only 13 times in December during the past 46 years, this December’s advance also reflects a genuine improvement in the economic environment and the prospect of further fiscal stimulus in the US. Equity investors also need to keep in mind that the first four months of the year also tend to be positive, having delivered an average monthly price rise of 0.9% for US equities over the past 46 years, above the overall average monthly return of 0.6%. We believe equities will be propelled higher in 2011 by an improving economic environment and stronger earnings, and expect them to outperform both government and corporate bonds next year.
  
• New stimulus plan is good news for US equities
  
  New fiscal stimulus plans mean that US 2011 GDP growth will probably be in the range of 3-4% rather than the 2.5% we were anticipating just a few weeks ago. Revising up our estimate for economic growth boosts our forecast for corporate earnings growth from 12% to 16%-20%, and suggests that the 13% consensus expectation is too low and likely to be upgraded. This process of earnings upgrades should be supportive for equity markets.
  
• A virtuous circle of improved credit conditions, small-business confidence and job growth is emerging in the US
  
  There are clear signs that the US economic environment is improving, even ignoring the fiscal stimulus. A virtuous circle of improving credit availability, small-business confidence and positive labour-market data is emerging in the US. The key reason that jobless claims have stalled at a high level for most of the year is that small firms have continued to make substantial layoffs even as larger businesses have started hiring again. It is no coincidence that jobless claims have fallen below the range they have been trapped in since the start of the year, just as small business sentiment has finally started to recover somewhat, driven by improved credit availability. We expect both of these trends to continue over the next few months, which should boost December payrolls by about 50,000 more than November’s 39,000 figure.
  
• Signs of stronger growth weigh on safe-haven government bonds
  
  Government bond markets in the US, UK and Germany suffered a second consecutive week of price declines, pushing yields higher amid signs of stronger growth. US ten-year yields have risen from 2.4% in early October to nearly 3.6%, initially driven by rising inflation expectations following the US Federal Reserve’s (Fed) announcement of further quantitative easing (QE). However, the improving growth environment since the start of December has triggered a rise in real yields, which are adjusted for inflation expectations.
  
• A rise in US 10-year yields above 4% is unlikely, barring rate-hike expectations or fiscal contagion from Europe's periphery
  
  Ten-year US Treasury yields are unlikely to rise above 4% in the next few months, given how steep the yield curve is, unless the market shifts to pricing in rate rises or fiscal contagion spreads from Europe’s periphery to the safe-haven bonds of the US, UK and Germany. For example, a further 0.40 percentage-point (pp) rise in US ten-year yields would make the US yield curve as steep, measured by the difference between the Fed policy rate and 10-year yields, as it has ever been in the aftermath of a recession. For yields to rise further than that, the bearish steepening that we have seen since early October would have to give way to a bearish flattening, where short rates rise faster than long rates in anticipation of rate hikes. This is unlikely while the Fed is engaged in QE.

Indices, Interest rates and Inflation

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