The key issue for the markets to contend with in 2010 is the risk that the economy slips back into recession (the so-called “double-dip”).  As the banks have now been largely fixed, should the economy double-dip then it is likely the retailers will be foremost amongst the suffers.   

The retail sector had a strong rally last year as the stockmarket discounted a recovery.  If we use MKS as a proxy for the sector, they rallied from just above 200p in Dec 2008 to finish at the 400p mark, with the annual dividend cut to 15 pence along the way.  The risk now is that the consumer gets squeezed after the May election and consumer spending suffers as a result.  Even if consumer spending does manage to hold up, the sector has already priced in a recovery and there is not enough upside left to reward investors sufficiently to risk owning the shares.  If the sector continues to trade lower then at some point it will make sense to buy back in for the next recovery trade.

A second sector to be very careful of in 2010 is the pub & restaurant sector.  Wet-led tenanted operators such as ETP and PUB are going to continue to struggle whilst their food-led competitors MAB and MARS may fare relatively better.

It is likely that a newly elected government will both cut spending and signal tax rises once the economy is strong enough to bear them. The Government has a massive hole to fill in, net borrowing will end up somewhere around £175 bln in 2009/10 and £180 bln is forecast for 2010/11.  The fact that this is 12.5% of GDP does not tell the whole story as it also represents 39% of pre-credit crunch tax receipts.  The government’s income has fallen by 12% over the past two years but spending has yet to be cut by a single penny.  The emperor has no clothes – Gordon Brown will not countenance spending cuts and doesn’t have any money to “invest in services”, whilst the best David Cameron will be able to do is maintain spending on the NHS and cut spending significantly everywhere else. 

Take a minute to think about the mountain that needs to be climbed in the UK.  Central government total tax income is forecast to be £397 bln in 2009/10.  Adding on £175 bln net borrowing implies total government spending of £572 bln.  In the best year ever, total taxes raised were £451 bln (2007/8).  Its going to be a long, hard slog to get back onto an even keel and it will take years to fill in this particular hole via a combination of spending cuts, tax rises and hopefully renewed economic growth causing the tax base to grow as well.  The Bank of England will wait a very, very long time before risking any rate rises against this backdrop – it is more likely that QE will be resumed (from its current £200 bln) to support the economy/gilts market before any QE exit strategies are implemented.

At the moment the retail sector carries all the risk of being first in the firing line should consumer spending weaken and lead the wider economy into a double-dip recession.  Avoid retailers until the sector offers patient long-term investors a much better risk/reward.

The Fed and the BoE are going to allow themselves to fall behind the curve as they seek to hold rates low whilst an economic recovery gains traction and begins to absorb some of the spare capacity which has been created by the recent recession (i.e. unemployment falls and manufacturers’ capacity utilisation rises).

We saw the first inklings of how this will play out in practise after last Friday’s US employment report.  A stronger than expected 4th December 2009 report (which showed the unemployment rate falling by 2/10ths and non-farm payrolls essentially unchanged at -11,000, together with the prior two months revised to show 159,000 fewer jobs lost) caused the market to price in a rate hike by the Fed in Q2 2010 and the Dollar rallied on expectations of US rates rising.  However the Fed will probably keep rates on hold for far longer than the market currently thinks and we are going to see repeated attempts by the market to price in a series of rates hikes which will fail to materialise on time as the Fed stays firmly & willingly behind the curve.

So the US and UK yield curves are likely to steepen further as the Fed and BoE deliberately keep rates on hold whilst an economic recovery builds strength and they will want to see their respective unemployment rates much, much lower before they dare to begin hiking rates.  The press may ascribe 10-year Gilts selling off (higher yields) to worries about Labour’s complete unwillingness to sketch out a plan to bring the budget deficit back under control but actually the gilts market doesn’t care about Labour’s economic plans because the view at the moment is that the Conservatives are going to win next May’s general election and it will be their budget plans for 2010-15 which will matter. 

The more likely explanation for higher 10-year yields is that government bonds always sell off when the market scents economic recovery and last Friday’s US employment report hinted towards a sustainable trend of lower unemployment and consequently stronger GDP ahead. This is also why the strong correlation between a weaker Dollar & stronger stockmarkets (which has been maintained since stockmarkets bottomed in March 2009 all the way up until last Friday) now appears to have broken down. Markets are now sensing growing GDP which implies corporates will grow their top line sales (hence higher profits, so the stockmarket rally continues) and growing GDP also implies US Dollar strength after the weakness we have seen in the last 9 months. 

Given that low Base rates are here to stay for a long while yet, which assets will benefit most from the BoE’s low-rates-for-yonks policy (which is primarily directed at halting the recession and, as a consequence of growth, reducing unemployment)?

Normally government bonds sell-off (higher yields) when the market sniffs an economic recovery but with so much spare capacity in the economy to be worked through, Base rates will remain low until a recovery is well under way and unemployment has turned decisively lower.  In this environment short-dated government bonds should continue to do well, especially for those within 5 years of maturity.  Longer-dated yields may well go higher (especially once the BoE finishes spending its QE money) with the result that we may see a very steep yield curve sustained for quite some time.

Credit spreads on corporate bonds should carry on tightening, although there will come a limit when the absolute level of the coupon offered scares investors – lending money to a BBB-rated corporate at, say, 3% for 5 years will surely make investors think twice.  The margins currently enjoyed by banks will also serve to stop credit spreads from tightening too far as banks enjoy better protection on their loans (so logically the credit spread on corporate bonds ought to be greater than banks’ lending margins).  A steep yield curve also benefits banks greatly too.

Commodities follow a price path all of their own as they offer no yield, so they offer little attraction to income-seeking investors.

Which brings us to equities. Yields in excess of government bonds coupled with low Base rates until a recovery appears mean that equities could quite easily become over-valued against the current backdrop of macro policy.  Companies with big pension schemes may not join the party as the combination of tightening corporate credit spreads and bond yields being held down by QE buying will result in lower AA-bond yields (which are used as the discount rate with which pension scheme liabilities are calculated).  This will temporarily result in bigger pension scheme deficits which the market may well take fright at (again) for those companies affected (the usual suspects are British Airways, British Telecom, etc.), but the effect will subside once the BoE stops propping up the gilts market and long-dated gilts sell off (higher yields).

Once the supply of fresh equity from companies raising money to pay down debt and get their balance sheets into better shape has largely abated, the coast will be clear to bid up the price of equities.  Any type of a recovery (slow & protracted would be ideal) will result in companies growing their top-line sales revenues, whilst all the cost-cutting implemented since the credit crunch hit in summer 2007 means that lots of that top-line growth will translate into higher profits.  And high unemployment rates also mean that workers won’t be getting much of this profit growth.

The obvious risk to this all-out bullish view is that the economy double-dips badly and the hoped-for GDP growth never materialises.  Until that prospect (which looks very unlikely at the moment) seems much likelier to happen, it will not pay to be bearish on equities.  The Bank of England is too worried about spare capacity bearing down hard on inflation to care much, for the time being, about an asset bubble developing in equities.

So two central banks have led the way and raised interest rates (Australia and Norway), starting their journey on the long way back to interest-rate normality.  But it does not necessarily follow that just because two commodity-linked countries have started to hike rates, the Fed, BoE and the ECB are about to follow suit anytime soon. Speculation that the Fed and BoE are contemplating rate hikes is way too premature – the order of events will surely be for Quantitative Easing spending to be halted first and only then will the central bankers turn to taking back some of the rate cuts they have implemented since the summer of 2007.

The US has recently reported GDP turning positive in the third quarter of this year but the US economy is still far too weak for the Fed to risk halting QE anytime soon, let alone even think about raising interest rates from their current floor of 0.25%. One positive quarter of GDP is just the start of a potential recovery  (which could easily fizzle out again next year) and the Fed made it clear in their Fomc statement earlier this week that rates are staying put “for an extended period” and the Fed won’t even finish spending its current $1.75 trillion QE money until the end of March 2010. As was announced today, US unemployment is still rising and has now reached 10.2%.

Similarly the Bank of England this week increased by £25 bln its QE target to £200 bln, to be fully spent by the end of January 2010.  The BoE will most likely decide to print even more money if GDP does not return to growth in Q4 (after the surprise of the UK posting another quarter of recession in Q3).  As the BoE will not raise rates ahead of next year’s General Election, theoretically the ECB is in line to be the first of the major Western central banks to implement a rate hike as they never embarked upon QE in the first place.  However the jury is out on whether the ECB will raise rates with Spanish unemployment of almost 20% and with Ireland looking set to go to the IMF to seek a loan.

Inflationary pressures will not be seen in the UK until a lot more of the £200 bln QE money finds its way off deposit at the BoE (where £151 bln currently sits) and out into the wider economy where it can begin to chase the price of goods & services higher.  Therefore the BoE will only come under pressure to raise rates in the near term if the Pound Sterling collapses.

So the sight of central banks raising rates looks to be spotted for the time being only in the economies of the world which export commodities.  China will probably be the first Asian central bank to increase rates because the Yuan is closely tied to the US Dollar and other Asian countries do not want to raise rates and cause their currencies to appreciate against the Dollar or the Yuan.

It is broadly accepted that we got ourselves into this mess by allowing the banks to lend too much, too cheaply to people who were not really able to pay back the loans they shouldered.  The way out (whilst avoiding a depression caused by deflation & debt-induced personal bankruptcies) involves making existing loans servicable whilst at the same time not allowing people to add to their current debt burdens.  Hence there is a delicate tightrope to be walked along by lowering interest rates for existing borrowers but simultaneously rationing the availability of credit at the same time so that we do not dig ourselves a deeper debt hole than the one we are already in.

Credit can be rationed in two ways, either by restricting the availability of credit (via very strict lending criteria) or by raising the cost of credit (only extending new loans at high spreads over Libor or Base Rates).  Banks are currently not lending freely for many reasons which include households & corporates being unwilling to borrow, the banks wanting to make profits to rebuild their balance sheets and the knowledge that UK banks are going to have to refinance most of the maturing sterling loans which were previously extended by foreign banks (who have now all but ceased lending in the UK), amounting to roughly £80 bln annually over the next few years.

If we are ever to escape consumers having too much debt then the cost of credit needs to be kept high otherwise very low borrowing rates will simply encourage more borrowing which will prove too expensive to service when base rates eventually normalise towards the 5% level (this prospect is at least two years away).

Consumers paying down debt, however slowly, will keep the Austrian School happy as they believe the economy will never recover properly until the high debt burden is worked off.  The Bank of England may well be trying to encourage the banks to move the money they have on deposit at the BoE and lend it into the real economy but it is in no-one’s interest for this to be achieved by the banks lending at very low margins to borrowers of poor credit quality.

The upshot is that any recovery is going to be slow and protracted and banks are going to be making a lot of money during the long, slow recovery as defaults and loan loss provisions will eventually subside but banking margins will remain high as consumers will continue to be charged high rates for borrowing (personal loans, credit cards & mortgages).

The good news for the Government is that UK banks making big profits imply lots of future corporation tax revenues from the banking sector.  However, if banks make hay for long enough then eventually there will be calls for a windfall tax to be imposed on the banks “excessive profits” but that prospect is many years away (although it is hard to envisage a cash-strapped Government resisting the temptation to levy a windfall profits tax - but surely only after they have sold the UK banking shares they currently hold (LLOY, Northern Rock & RBS) at a good profit for the taxpayer).

The Bank of England continues to do its best to debase Sterling by printing as much money as possible without scaring the gilts market.  The only reason Sterling hasn’t collapsed against other currencies is that the other major central banks are all involved in various forms of printing money (quantitative easing) themselves.  Sterling is however steadily weakening against the Euro as the ECB is the only major central bank not currently printing money freely (see Vee are Not Embarking on QE).

But the BoE has shown it means business by recently increasing the amount of money it is planning to print from £125 bln to £175 bln and the Governor letting it be known that there is more money where this came from as he would rather print £200 bln.  The Governor is doing his best to stay ahead of the likely £175bln-plus of gilts to be issued this year.  However so far the QE money spent by the BoE has ended up mostly in commercial bank reserve deposits back at the Bank of England (a telling indication of just how much cash the banks now have is that 3-month Sterling Libor at 47bps is now below the Bank Rate for the first time since the credit crisis broke in the summer of 2007).  The challenge is how to get this money injected into the real economy given that households and corporates don’t want to borrow and companies are preferring to launch rights issues to fund their acquisitions with equity rather than debt (and the REITs are busy selling new shares to pay down their debts too). 

The BoE have hinted that the next trick they will try in their attempt to move the money currently held by the banks at the BoE is to stop paying interest on this money.  Given that the Bank Rate is only 50bps then reducing it to zero may not be a big enough incentive and the banks may well just shift the money into the very short end of the gilt market.  However not paying interest on commercial bank reserves will come in very handy when the time eventually comes for the BoE to start raising interest rates again, so we can expect this policy move to happen at some stage.  The more drastic step of paying a negative interest rate on commercial bank reserves (by charging the banks interest to deposit money at the BoE) will achieve nothing as the logical response from the banks would be the same – shift the money into short-term gilts.

With everyone looking to raise equity and retire debt, getting the QE money into the real economy may take a quite a while longer to work (there is no history to refer back to here as the Japanese were too timid when they tried QE).  In the meantime the BoE has little option other than to carry on printing money until a sustainable economic recovery takes hold.  Expect Sterling to continue to depreciate against real assets and harder currencies such as the Euro.