Our thoughts on the year ahead

As is our tradition, we kick off the New Year with our annual Outlook in which we give our take on the lay of the land, and propose our top ten investment themes for 2010. We resume publishing in our normal format next week.

In recent days we have not only heralded in a New Year but also a new decade, so it is worth taking a moment to reflect on the passing of the noughties as well as another 12 months.

The past 10 years have certainly proved a ‘naughty’ time for investors, with the decade starting and ending with two periods of substantial financial stress. The catalysts were of course quite different. The dot com bubble saw a correction of sky high technology and telecoms valuations which were built around a (false) new paradigm. The most recent collapse in global asset prices has ultimately had its roots in the unravelling of loose and excessive credit in the financial sector.

The end result has been that on the face of it the noughties have been the lost decade for equities. Certainly not the decade to be a passive index investor in any case.

In fact, many markets performed worse than they did in the depression blighted 1930’s. The S&P500 for example fell 30.4% in the 1930’s but has dropped by around 38% since 2000.



And of course the medicine applied to both shocks in the past decade, although varying in degree and co-ordination, has had much in common – foremost of which has been an aggressive loosening of fiscal and monetary policies. So are we just creating the foundations for another bubble? And if so where will the epicentre lie next time? Let’s come to that later.

As is common at the start of each outlook we review our predictions from the year before. With the passing of the decade, it is also worth reflecting on our thematic calls as we approach our ten year anniversary.

Incepted after the bursting of the technology bubble, our overweighting of the mining, and resource sector, along with gold in particular has proven well founded. Whilst missing out on easy gains in the early stages of the bull market, our decision to stay clear of the financial and property sectors was vindicated. And although a value based investing style can have detractions in rampant bull markets, it is often the ‘go to’ approach in times of financial stress.

Turning to our predictions at the start of 2009 we were on the mark (in the end)…

“..throughout 2009 we will experience unprecedented government stimulus and this should provide support for asset prices. Central bankers are punishing savers heavily by slashing the rate of interest paid on cash. Staying in cash in 2009 will increasingly be seen as an opportunity cost, especially as inflation erodes the value of that cash. Particularly as official rates converge towards zero.

After such a horrendous year in 2008 we expect equities to put in a positive performance in 2009, although the extent of this is obviously dependent on many variables….Adding to our cautiously bullish view, sentiment currently remains very bearish. This suggests that many investors exited the market in 2008 and may now be sitting on the sidelines in cash.”

Whilst we did not anticipate the even deeper correction that would ensue in the first quarter of 2009, we were right to have full confidence in the unrelenting resolve of central bankers to boost waning asset prices. Ultimately setting the scene for not only a ‘positive performance in 2009’, but in fact one of the greatest market rallies in history.

The pace of the market re-rating has been truly impressive. The UK index for example has been the first major stockmarket to recover its pre ‘Lehman bust’ highs in the space of just 9 months.

So how will the markets fare in 2010?

When considering this question it is worth approaching the outlook from two levels – macroeconomic and microeconomic.

As the last two years have resoundingly shown, investors in today’s globally interconnected market place ignore international macroeconomic trends at their peril. A company may be soundly run, and quite profitable within its own industry at a certain juncture, and (more importantly) reasonably valued, but this counts for little in the near term if global investor sentiment is going against it.

Global attitudes and appetite for risk will necessarily determine what investors are prepared to pay for earnings. And certainly over the past year investors have become increasingly confident, as top level earnings multiples show.

A year ago, the S&P/ASX 200 for example was trading on a estimated full year price earnings multiple of around 10 times. Scroll ahead 12 months and the index earnings price tag has raced ahead to over 17 times.

A move to which we alluded in last year’s outlook:

“We think that investors will gain confidence from the considerable stimulus that will work through the system in 2009 and this should support the PE expansion thesis, despite the fact that earnings will likely remain under pressure.”

So it now seems that investors are pricing in ‘normal’ levels of earnings growth, and a ‘normal’ global macroeconomic environment.

The charts also underlie just how comfortable investors are that market stress is returning to more ‘normal’ levels. The VIX, or volatility index, has collapsed over the past year to around the mean, indicating dramatically less demand for protection from a falling market through the purchase of options.

What then would unhinge the collective view that everything is not so normal, and that significant downside risks remain?

Broadly speaking, a trigger would be any concerns en masse that the current recovery is a false dawn and that the global economy is facing a double dip recession.

We believe that the trigger for such a change in permanent sentiment is unlikely to be a one off event (such as the scare over Dubai’s debt problems) but rather sustained evidence that the improvement seen in key economic data over the past year is reversing.

Let’s not forget though that an integral part of the recovery story of the past year has been the unwavering commitment of governments and central banks to re-inflate the global economy. To date these measures have been successful on a number of levels. It is unlikely in our view that faltering economic data would coincide with aggressive monetary and fiscal tightening.

As we have often stated central banks know their history and are likely to be extremely reticent when it comes to tightening too soon. Many governments with creaking balance sheets (the UK is a case in point) might start to feel the need to pull back on fiscal stimulus, however monetary policy is likely to remain loose for some time in our view.

Key interest rates are therefore likely to remain low. Low interest rates should keep a lid on borrowing costs, adding significant support to corporate (non-financial at least) earnings.

Availability of credit should also continue to improve as well. Banks have adopted increasingly conservative lending practices over the past year or so. And who could fault this given the origins of the global financial crisis. However, government support and rights issues have enabled financials to repair their balance sheets, and with the recovery in the general business environment gaining some traction, we expect 2010 to be the year that the wheels of credit begin grinding in earnest.

Nevertheless, there are still significant headwinds to the recovery at both the micro and macro-economic level. Foremost of which in our view are the still elevated levels of unemployment in many countries across the globe, specifically the US.

Of course one argument is that unemployment is a necessary result of the pains of the past two years. Costs have been cut to restore profitability, and jobs have been cut as a result. Companies will expand again and re-hire as the business cycle heads upwards again. This notion has complete merit of course as long as the recovery does not stagnate and those displaced become permanently out of work. Enter the policy makers again…

Having averted financial sector Armageddon in 2009 we believe that 2010 will be the year governments and central banks throw all hands on deck to restore employment growth.

With the global economic revival finely balanced, putting people back into work is a vital part of the rescue jigsaw. Consumer spending is a substantial driver of economic growth (around 70% on average in the West), and to date has been boosted by various intermediate government incentive programs. A sustained improvement in jobless figures will provide a more sustainable and decisive leg up in our view.

A jobs revival and increase in collective well being (combined with an increased propensity to lend by banks) will also set the platform for a longer term recovery in the property markets. The personal-wealth-bolstering effects of which should further spur consumer spending.

However, a significant turnaround in unemployment data will not be achieved overnight.

As such, whilst we believe that the globe will avert a ‘double dip’ there are enough bumps in the road to recovery to vindicate an even more highly selective approach to stock and sector selection in 2010, particularly in the early quarters.

The property market recovery rebound for one is on shaky foundations. In the US delinquencies remain at elevated levels and the impact of the expiry of the first home buyer incentives in April will be closely followed. In the UK the fact that many house builders have swung from a deep discount to significant premiums to net asset values causes further alarm bells to ring (for value investors at least).

Given that the general going is unlikely to be plain sailing this year we continue to favour recession resistant businesses as we enter 2010. Whilst underperforming growth last year, defensive exposures, companies with robust cashflows and recession proof products are likely to find increasing favour with investors. This is particularly so in a low interest rate environment.

And the ongoing presence of low global interest rates (and future inflation) should continue to add fuel to the commodities story on which we remain resolutely positive. A key part of which is the emerging markets demand side, particularly China which has shown little real signs of unravelling. Over the past decade the behemoth has gone from the seventh largest economy in the world to third, and is closing in on Japan to take second spot.

We expect China’s consumption of metals, energy and soft commodities to continue at a robust rate, underpinning global demand whilst the West at large emerges from recession.

Also key to the resource story is the demise of the US dollar. And we see no long term respite for the greenback. A massive fiscal deficit (current and future) is likely to see the dollar’s mantle as the reserve currency of choice increasingly eroded through the year ahead and beyond.

And so enter gold as an investment destination which we continue to favour. Having broken through the US$1,000 mark in 2009 (as we forecast in last year’s outlook), the precious metal in our view is now preparing an assault on US$1,500 in 2010.

So, after a decade in which two bubbles imploded, are we seeing the early stages of another bubble, gold, commodities, equities generally?

Certainly there is every chance that a bubble is forming as we speak, however if history is anything to go by (and it usually is), it will take several years to play out. For the moment our primary areas of interest; gold, resources, and defensives do not appear overcooked from a longer term perspective. We will of course revisit this diagnosis throughout the course of 2010 and beyond.

After having their confidence shaken in 2008/early 2009, many an investor will be approaching 2010 in an optimistic fashion. We would urge an air of ‘caveat emptor’ as a New Year and new decade (the ‘teenies’ apparently) gets underway. A new calendar does not mean that a correction in certain areas of the market is any less overdue.

And as such patience and discipline remain important virtues as ever. The markets may have emerged from the gloom of 12 months ago in spectacular fashion, but complacency has no place in any investing manual.

As ever we will look to guide Members through 2010 as successfully as possible.

We would like to take this opportunity to wish all our Members a Happy New Year and we look forward to presenting a number of new investment opportunities in the weeks ahead.

All the best,

Fat Prophets

A discussion of the major themes for the year ahead

1. When will the Fed Tighten?

Mr Bernanke’s reappointment as Chairman of the Fed seems assured after he received Senate approval, but he has his critics. Appointed by former President George W Bush, and re-nominated by President Obama, he has been widely credited with averting financial disaster during the GFC. His critics say he was asleep at the wheel as the reckless mortgage lending raged around him. It seems the rescue operation has cemented his reputation though, with Time magazine naming Mr Bernanke as its Person of the Year.

Throughout the GFC, the Chairman of the Federal Reserve had one aim. That was to loosen monetary policy, dramatically, to keep credit flowing and avoid the mistakes that caused the Great Depression of the 1930s.

Almost a year later, most observers agree this was the correct thing to do. We understand the argument that recessions should run their course in order to return economies to a stable foundation, just as a forest fire clears deadwood and facilitates new growth. This is however an ideological view and clearly far from practical in reality.

In terms of Fed policy through the year ahead, cutting rates was the easy task. Deciding when to reverse monetary policy from these historically low levels requires significantly more skill with regards to timing and magnitude.

 

In this decision, the Fed faces the delicate prospect of acknowledging that the economy is beginning to recover, but not allowing inflation to take hold. After its final meeting for 2009, the Fed said: “Economic conditions, including low rates of resource utilisation, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

In translation, that means that while unemployment remains near its 26-year high at 10% and businesses are at a low ebb, then there is little prospect of an increase in interest rates. That is of course dependent of Bernanke’s re-appointment for another 4-year term. As we pointed out above though, we believe this is likely.

Turning to the numbers, the US economy reported annualised growth of 2.8% in the third quarter for 2009 providing some evidence that conditions are improving. Industrial production and consumer spending have shown increases in recent months, albeit somewhat pallid, but growth nonetheless.

The inflation boogieman has been largely contained to date, but the Fed will be wary of complacency. The November CPI recorded inflation of 0.4%, leading to its first rise of 1.8% on an annualised basis since February this year.

As each economic marker comes and goes next year, analysts, dealers, economists, bankers and businessmen will watch with baited breath for any hint that the Fed will begin to lift interest rates. Central bank statements are always closely scrutinised for their language, so that will be the first sign of a change in position from the Fed.

For now, the consensus opinion is that interest rates will not begin to rise until the first quarter of 2011. A 2010 rate rise certainly seems unlikely to us. As it has done in the past, the Fed will wait until unemployment is clearly in retreat, possibly below 8%, before they act.

As we have consistently stated in the past, inflation concerns are always likely to take a back seat to deflation concerns for the Fed. Premature tightening of monetary policy could still unwind Bernanke’s good work to date, with the result that tightening is more likely to be a little late than early. This is of course bad news for the US dollar.

2. Will the US dollar recovery continue through 2010?

The Greenback has served as an interesting barometer of global investor sentiment over the last 18 months or so. Following the September 2008 Lehman collapse, the US dollar index surged from a low of around 77.68 to approach 90 in November. The rally was caused by a rush to the perceived safety of US Treasuries as investors sought to capital preservation with little consideration of return.

After pulling back towards the end of 2008, the dollar regained strength in the opening of 2009 as equity markets continued to slide away. Once it became clear that policy makers would stop at nothing to turn markets around, the dollar steadily lost value as risk appetites improved.

The overall US dollar trend of 2009 was firmly down, punctuated with occasional bouts of strength as investors occasionally lost a little faith in the broader equity rally. That is until the final month of the year, which saw the Greenback stage a more meaningful recovery. The US dollar index lifted from 74.76 at the beginning of December, to close out 2009 at 77.86.

So, where to from here? Well, first and foremost we have not seen any evidence to alter our longer term bearish view of the US dollar. We therefore view the currency’s latest resurgence as nothing more than a correctional phase within the primary downward trend. As such, we would not expect the rally to prove sustainable for more than a few months and certainly not for the duration of 2010.

A key factor behind the dollar’s weakness is of course the Fed’s effectively zero interest rate policy. This has seen the dollar become the currency source of choice for the carry trade. Traders are able to borrow dollars for next to nothing, before selling them to invest in higher yielding assets, including non-dollar denominated bonds.

The dollar’s December rally was largely a function of better than expected economic data, November US payrolls data in particular. This raised the fear that the Fed may begin raising interest rates earlier than previously expected, thereby triggering an unwinding of the carry trade and consequently greater demand for US dollars.

Future economic news flow from the US will of course be incredibly important in determining the dollar’s movements through the months ahead. As we have discussed above though, we do not expect the Fed to raise rates before the recovery is well and truly established. Even when the Fed does begin to tighten monetary policy, it will not do so at anything like the pace at which it loosened. This should ensure that the US dollar carry trade remains both viable and in place for some time yet, consequently limiting the dollar’s ability to maintain a sustainable rally.

3. Will a second wave of US mortgage defaults cause a repeat of the sub-prime crisis?

The wave of subprime defaults that triggered the US property market meltdown and the GFC are thankfully in the past. The bad news is that a second wave of defaults is potentially on the horizon, driven by other mortgage classes scheduled resetting to higher rates of interest. These are specifically Alt-A and Option ARM mortgages.

The volume of mortgage resets associated to these classes of debt will begin to expand this year, before peaking in mid-2013. Indeed, while the level of sub-prime delinquencies is tapering off, delinquencies among other mortgage classes such as Alt-A are beginning to pick up.

The US property market is at the root of the GFC, having inflated into a gargantuan bubble under the excessively low interest rate policy of the post 9/11 Greenspan years. Bernanke recently argued against blaming the Fed for the bubble, instead pointing the finger at inept regulation that facilitated the property bubble and even magnified it through the slew of structured products that Wall Street engineered around it.

Bernanke is correct in that tougher regulation could have prevented the crisis. He cannot however ignore the fact that Fed driven easy credit facilitated the bubble-inflating environment in the first place. Given that very few people buy houses without the use of borrowed funds, it is quite clear that the availability of credit is central to a housing bubble.

This is evident in the data. According to the Fed’s own figures, the total value of US mortgage debt has increased from $18.6 billion in 1945 to $10.5 trillion today. Perhaps more importantly though, the level of equity in US homes has slipped below 50% in 2008 and continued to slide last towards 40% last year.

On the face of it, a 40% equity cushion appears sufficient to guard against further falls. The problem is that households that have paid off their mortgages serve to skew the figures. The actual equity cushion for mortgaged properties is probably below 20% overall and would already have been entirely eroded in some cases.

The prospect of a second wave of sub-prime type defaults has the potential to seriously destabilise the US property market and consequently also the recovery process. From our perspective, while this second wave of mortgage resets is certainly not good news, we do not believe it will have anything like the impact of its sub-prime predecessor.

First and foremost, everyone from mortgage holders to the banks and financial sector in general can see this coming. One of the reasons the sub-prime crisis had such a devastating impact was because it came out of nowhere as far as the majority of banks and individuals were concerned. Since then of course, banks have bolstered their balance sheets against further losses through capital raisings, bailout funds and importantly, positive earnings.

A second key issue that amplified the impact of the sub-prime crisis was the extent of securitisation. Because the failing mortgages were bundled into other tradable financial products, the financial institutions holding them had to recognise market-to-market losses immediately.

The collapse of the structured product market has already occurred, so even though further losses will occur, they will come through over a longer period. This mitigates their impact, given that current earnings will have greater capacity to offset them. This doesn’t mean there won’t be some corporate casualties. Smaller banks will continue to fail in the US, as they have done through 2009. However, it does remove the threat of systemic collapse that the sub-prime crisis so nearly caused.

Other points to consider are that lenders will no doubt be working with mortgagees to ensure they are able to keep their homes though extended maturity periods and other methods. Not all borrowers will qualify for such assistance of course, but many of those that don’t have likely already joined the casualty list. In addition, the currently low interest rate environment serves to limit the extent of the mortgage resets. This is also a further reason why we believe Bernanke will not lift interest rates anytime soon.

All in all then, our take on the pending wave of Alt-A and Option Arm resets is that it will create a headwind to the recovery. It is however considerably more manageable than the previous sub-prime meltdown due to its more drawn out impact, the balance sheet repair that has already occurred and the more accommodative interest rate environment.

In short, this issue does not pose a systemic threat and any market volatility that it does cause will be more in the form of a ripple than the tsunami that came before it.

4. China

There is no escaping China as a Top 10 Theme for 2010. 2009 was a year that most Western and Eastern European economies would like to forget – it was a miserable year. Australia was however an exception because of strong demand for bulk commodities and metals from China.

At the beginning of 2009, rising metals prices were attributed to the Chinese re-building inventories. China re-stocked and most metal prices held up. A massive stimulus package made sure the downturn in China was short. One commentator summed it up quite nicely by stating that rather than going from boom to bust, China simply went boom, pause and back to boom.

Positive investor sentiment pushed the share prices of leading resource companies skyward. Majors such as BHP Billiton and Rio Tinto were very strong stock market performers.

The question that must be asked now is: what does the future look like?

China barely blinked before its recession was over, with the goliath of growth reporting that industrial output grew at an annual rate of 19.2% in November 2009. More importantly, heavy industrial output grew at 22%. At this pace, output is doubling in just over three years. Going forward, this rate of growth will have a profound impact on the demand for raw materials.

China’s transportation sector was its strongest sector for the first 11 months of 2009. The output of motor vehicles rose 31.3% over the previous year, boosting demand for metals and oil.

November saw some very big increases in terms of volumes. Production of motor vehicles reached 1.44 million units – this represented an annual increase of 100.8%. About half these vehicles were cars, with car production rising 87.4% in November on a year ago.

Increasing traffic is hiking the demand for fuel. China’s imports of crude oil are going to keep soaring and have already accelerated past 4.5 million barrels per day. The next milestone, which we believe is quite achievable, is 6 million barrels per day.

Indeed, when we look at the pace of oil imports, it is well within the realms of possibility that by the end of 2012, China might be importing 7.4 million barrels per day. By 2015 the imports might have jumped to 15 million barrels per day. This is of course very bullish for oil.

The process of urbanisation in China will continue for many years. For the first 11 months of 2009, urban fixed investment rose 32.1%, which was in line with increases in industrial output.

Investment in fixed assets is currently doubling every 2.2 years, underpinning strong future demand for raw materials.

From early 2002 to late 2008, China’s growth in heavy industrial output was doubling in less than 2 years. This was an extraordinary rate of growth, and probably unmatched in human history.

There have been a couple of slow periods concerning imports of iron ore since the start of 2004, but demand has mostly doubled every 2 to 3 years, and for the last two months, imports are doubling in less than 2 years.

In short, China has vindicated our view that its financial strength and growing domestic economy would allow its growth to continue despite the negative impact of weaker export markets. There is no change to our opinion that the nation’s historic industrialisation process has many years yet to run.

5. Commodities

Two key factors will make sure that commodity prices rise in 2010, but perhaps not to the last cycle highs. As we outlined above, China’s economy is racing towards pre-GFC levels of activity. Continuing strong economic growth in China has surprised on the upside and China's GDP is expected to grow by at least 9.5% in 2010.

China’s impact on world metals markets has been profound. China accounts for nearly 40% of the world’s consumption of major base metals. This is based on apparent consumption and takes no account of the net trade in the metal content of finished and semi-finished goods. By the same measure, the US accounts for only about 10%.

Meanwhile, the US economy is beginning to recover. There is however some debate about what shape the US recovery will take. These range from “U” to “W”. In terms of the historical precedent, most of the recoveries in the US over the last 40 years have been “V” shaped, with the only “W” occurring during the 1981-1983 period. Each month of new data released in the US makes a “V” shaped recovery more likely.

An economic recovery for the US is critical for a hike in metal prices during the course of 2010. Manufacturing companies will restock as new orders for durable goods rise. At the same time, commodities will become increasingly attractive to speculators and investors, adding to upward price momentum.

In terms of demand for base metals in the US, industrial production lags orders by 6-9 months, sometimes longer for major capital items. Orders for durable goods are starting to recover and we should start to see US demand positively impact metals by the second half of 2010.

As the global recovery continues to take hold, supply will once again become an issue and actual and perceived shortages will occur. This should see metal inventories whittled away, albeit some faster than others.

The start of a business cycle is an exciting time. It is not often that investors have an opportunity to buy into the sector at or near the bottom of the market. 2010 is one of those years, although share prices are already becoming reflective of the good times ahead.

The stage is set and the first act is about to begin.

6. Global Politics

Climate Change

It is yet to be determined if the Kyoto Protocol achieved anything meaningful towards the global theme of climate politics. In a similar fashion, the global forum in Copenhagen was nothing more than a photo opportunity for politicians and riot training for police.

But many countries and businesses on an individual basis are indeed serious about their contribution to reducing harm on the environment in its many forms. At the corporate and individual level, at least, there is definitely a ground-swell of desire, action and activity that in aggregate could become significant over an extended period.

Australia’s near miss on legislating for a carbon emissions trading scheme may still be a pointer to future government imposts on business. Having seen that program in reasonable detail, it can be assumed that the real costs to business and industry will be large.

At the core of the transition will be support for developing economies to adopt cleaner technologies and reduce the growth of emissions.

China and America’s participation may be the stumbling block to any global agreement. The predilection for self-interest cannot be underestimated.

There seems to be a willingness to accept the scientific evidence for global warming, but the solutions forthcoming so far seem more about political populism than economic sanity.

Banking Regulation

One of the generally agreed causes of the global financial crisis was attributed to lax regulation of financial institutions. Too much self-regulation and not enough rigorous oversight have been blamed for much of the crisis. This is certainly a valid point, although we think Bernanke went a little too far with his recent comments that lax regulation rather than monetary policy should take the blame for the GFC.

Nevertheless, having bailed out many of the world’s largest financial institutions with taxpayer funds, world leaders are now beginning to deal with the concept of prevention.

Since the beginning of 2008, 155 banks, savings banks and thrifts have failed in the US, according to the Federal Deposit Insurance Corporation.

Fixing the problem will not be easy considering its extent. First on the list seems to be a general agreement that the level of capital required must rise and tougher regulatory standards all around will be necessary. But beyond that, issues such as requiring institutions to gain approval for innovative new products is causing consternation among financial businesses used to a significant degree of freedom.

Another major stumbling block has been executive compensation. Around the world, the financial industry has always been known for its unworldly salaries and bonuses that to ordinary folk sound like plain greed. But attempting to rein in the apparent excess may prove futile.

President Obama vented his frustration at the industry saying: “I did not run for office to be helping out a bunch of fat cat bankers on Wall Street”. He pointed to recent multi-million dollar bonuses and contrasted that with the country’s 10% unemployment problem. The banks’ reluctance to lend money to businesses and consumers is at the core of his displeasure.

Britain’s David Cameron, potentially the country’s next Prime Minister, suggests that it is a question of better regulation, not more, that could help prevent a repeat of the GFC. He argues that the Bank of England should resume responsibility for carrying out industry oversight.

The British view does however conflict with the US Senate’s current legislation, which seeks to create a single entity banking regulator and remove some of the Federal Reserve’s authority to regulate banks.

The issue of regulation was characterised last year by a huge amount of talk and very little action. We suspect the same may be true this year, although some change will inevitably come through at some point. Regardless of what action is taken, short-term bubble inducing behaviour will always find a way to re-establish itself somewhere in the future. It will therefore continue to be incumbent on all investors to remain alert to imbalances and wary of herd-like behaviour.

Iran , North Korea

Afghanistan and Iraq have consumed an enormous amount of world attention and military effort for several years now. But Iran and North Korea remain potentially more difficult propositions if only for the nuclear threat that each might present.

Iran’s intention of enriching uranium for use in a medical research reactor has most of the western world alarmed at the possibilities. In October, negotiators from the US, France, Russia and the International Atomic Energy Agency reached an agreement for Iran to ship most of its low-enriched uranium out of the country for further enrichment, before reclaiming it. Iran has reneged on the deal already.

The UN is considering extensive economic sanctions against Iran by early next year, but this could simply antagonise the Islamic nation. The US national security adviser, General James Jones, however, ominously suggested steps to penalise Iran may not stop there.

After testing a long-range ballistic missile in May, against UN sanctions, North Korea has continued to do its own thing in defiance of western world demands. Weapons shipments are commonplace and only occasionally intercepted. North Korea mostly uses smuggled weapons to earn desperately needed foreign currency. Analysts have linked North Korean arms sales to many of the world’s hotspots.

North Korea’s withdrawal from the Nuclear Non-proliferation Treaty in 2002 was probably a more serious act and it has tested nuclear devices in the past. North Korea, known to be brutally tough on its own people, certainly qualifies as a rogue nation and certainly one that needs to be watched closely.

7. Dubai unnerved investors – are more shocks in the pipeline?

With recovery being the main feature for equity markets through 2009, news of Dubai’s potential debt default late in the year served as a useful gauge as to the extent of the market’s susceptibility to some form of negative shock. Investors initially reacted swiftly with fears that Dubai would mark the beginning of the final phase of debt defaults, that of sovereign credit. The ensuing sell off did highlight the frailty of investor nerves, particularly when given a reminder that the de-leveraging process in many parts of the globe is far from over.

Abu Dhabi eventually came to Dubai’s rescue. However, with Greece threatening to repeat the trick questions over further sovereign debt shocks in the months ahead will not go away. Similar to the UK, Greece’s budget deficit is set to come in at over 12% of GDP in 2010. More alarmingly though, while total public debt in the UK is set to hit 80% of GDP (more or less the EU average) Greece’s debt is set to reach a ludicrous 125%.

Given the response of the world’s bankers to the global financial crisis, it is little wonder that the paper currencies are being debased and budget deficits are being stretched. Indeed, there are particular sensitivities about government debt at the moment. Bond issuance in many countries has reached record levels due to the various economic stimulus programmes, reduced tax revenues and bank bail-outs.

Ever since the Dubai World story broke, investors - and ratings agencies - have been taking a fresh look at the indebted countries. Should budget reports fail to provide a roadmap to surer finances, we can expect sovereign bond markets to reflect investor concern, as they have done so in Greece.

Emerging markets may have adopted conservative practices however they are not immune from shocks. Despite their superior growth prospects, many are still getting to grips with the finer points of democracy and although longer-term development should lead to better governance, it will pay to be cautious towards countries that pay only lip service to reform.

As for corporate bonds, defaults in 2010 cannot be ruled out. Unemployment in the Western world remains high and property markets are subdued. Should this lead the banks to reveal a new wave of asset writedowns, there will be ramifications for all grades of debt. Small and medium sized businesses are however most exposed.

Overall, there will almost certainly be negative surprises as the recovery continues to unfold. It is however important to remember that shocks of the GFC’s magnitude are not regular events. Although the world is still dealing with its aftershocks, they are receding, and the global recovery is under way. The impact of any unpleasantness that is still in the pipeline will be to lengthen the recovery, rather than return equity markets to the unprecedented volatility levels of 2008.

8. Banking sector outlook

Somewhat ironically, having begun trying to save the jobs of bankers the UK government has ended it with a highly populist round of banker bashing taxes. A sign of things to come perhaps?

The health of the broader economy and resultant banking impairment levels will of course prove key determining factors for the banking sector in 2010. Given the threat of increased regulation, with its associated impact on earnings, the jury remains out on the financials. This is however more of an issue for the US and UK markets, with Australian banks standing head and shoulders above many of their global peers.

Earnings reports amongst the worst affected banks (in the UK and the US) over recent quarters have been spurred on by impressive investment banking and trading performances. In some cases we have also seen growth in deposits and synergistic efficiencies from takeovers.

Loose monetary policy has enabled banks to borrow cheaply but they have yet to extend the same privilege to consumers or small businesses, given their wariness that economic conditions could deteriorate again. Once the banks have sufficient evidence that a double dip recession is not on the cards, they are likely to drive earnings growth through higher lending volumes.

However, question marks remain over the details and impact of banking regulation and hence the outlook for the global banking industry in 2010 is clouded by uncertainty.

In a recent speech, Mervyn King, the Governor of the Bank of England, called for ‘utility banking’, which would tie banks down to more conservative practices such as financial intermediation and payment facilitation - as opposed to ‘gambling’ with taxpayers' and depositors' money.

In the United States talk of a new Glass-Steagall Act, to separate commercial from investment banks, has gathered momentum. The former would behave and be protected, while the latter could do as they pleased but without government help. Whether this is a silver bullet remains questionable as it was bad lending to commercial property which lay at the root of the problem. However, a reintroduction of the system dropped in 1999 would reduce risks, reduce bank size and prevent conflicts of interest, which are all positive factors.

Another regulatory measure being mooted is the aligning of pay with long-term performance to ensure that traders and bankers are not encouraged to take potentially de-stabilising short term risks. This is a sensible concept, although very difficult to enforce in practice.

Governments are also looking at breaking up banks in order to increase competition and ensure that none are too big to fail. While a tighter grip on capital adequacy will provide more confidence and stability, uncertainty as to the extent of other regulatory measures still leaves many unanswered questions.

Banking stocks have had a terrific run during 2009 however their robust performance came from extreme lows and the associated risk was high. The sector’s increased transparency has subsequently adjusted its risk profile. Should earnings remain resolute and impairments limited, the sector may yield a viable investment play or two during the next 12 months. We do however have more confidence of this in the Australian market than elsewhere.

9. Will direct government investment begin to unwind and will the “too big to fail” companies be allowed to exist?

A legacy of the corporate bailouts has been a dichotomy between firms which have been able to pay the money back, as markets recovered, and those which have not. On Wall Street the biggest financial firms have now paid back the TARP money and therefore escaped TARP related restrictions. Firms which have Government equity stakes are unlikely to be able to pay back the capital for many years to come and these include Citigroup as well as Detroit’s automakers.

In the UK financial firms can be split into those which have needed support and those which have been strong enough to survive. Certain institutions have been nationalised while others have seen the UK Government take stakes in their businesses. These include Lloyds HBOS and RBS group and unfortunately the prospects remain remote that capital will be returned in the near future. Both in the US and the UK, therefore, state supported institutions look set to limp on for many years to come.

With regards as to whether these “too big to fail” organisations should ever be allowed to exist, the answer is probably no. It is however difficult to call whether the political momentum is strong enough to carry out the reform that breaking up the goliaths would require.

Two US Senators are however currently sponsoring a law aimed at splitting up financial institutions. We will follow this with interest. Given the practical difficulties associated to such a move, it is likely to be an issue that fades into the background as time goes on.

Bernanke’s recent comments regarding inadequate regulation as the root cause of the crisis will probably trump any real efforts to limit the size of financial institutions. Indeed, would it really make any difference if the financial sector had been comprised of many more, smaller organisations? If the majority still became involved in destabilising practices, government support would remain a necessity.

10. Property market outlook in Australia and the UK

With new challenges facing both the UK and Australian property market it remains to be seen whether high prices can be sustained. Both markets have seen property booms in recent decades which have stretched affordability levels to extremes, albeit less so in Australia. With stricter credit criteria due to the credit crunch and weaker economic conditions, the prospects for further property price rises may be limited.

Property, for many, is more than just an asset class. It is an investment which is seen as reliable and guaranteed to go up over the long-term. During the later stages of the UK’s property boom a cult-like faith in bricks and mortar developed, with people willing to take on huge amounts of debt for speculative off-plan flats. While this market froth may have dissipated the inherent belief that property is generally a good bet does seem to remain.

A key driver of the property booms in Australia and the UK has been the increased availability of credit. The Reserve Bank of Australia limited the extent of Australia’s property bubble through more prudent interest rate policy than was the case for the Bank of England. Australian lending practices also did not reach the level of lunacy that was the case in the UK and also the US. This is a key factor behind the resilience of Australian property relative to other countries.

Nevertheless, the growth of property prices has been much faster than the growth of underlying economies. As a consequence the ratio of house prices to wages has increased as property became “re-rated” relative to average wages.

With this backdrop clearly the rate of property price increases in recent decades cannot be sustained indefinitely. Lower interest rates may have enabled the re-rating of property relative to wages, by making re-payments more affordable, but that process has to end at some point. To use a famous quote: “What cannot go on forever must stop”.

This means that expectations of property doubling every 7-10 years, as is often touted by those with a vested interest, are unrealistic. Going forward the rate of growth for property will at best be equivalent to wages growth which increases at a moderate rate in line with economic growth.

Against this constraint for the rate of future growth we also have to consider the prospect for price falls and/or the market stalling. To date Australia’s property market have held up relatively well in comparison to others. Even the UK market has not melted down to the extent many had predicted. Markets such as the US, Spain, Ireland and Eastern Europe are among the worst performers.

Key reasons behind Australia and to a lesser extent, UK property’s resilience is that neither market was plagued by the chronic oversupply issues that crippled the weakest markets. On the demand side, populations in both nations have been increasing, which in turn puts pressure on the stock of available houses.

It is important to differentiate real demand from aspirational demand with regards to property though. Demand cannot convert into transactions if funding is not available and the cost of funding is therefore critical to real demand.

Rising interest rates in Australia could see property suffer this year, especially as Government grants have encouraged marginal buyers to buy their first homes. Similarly in the UK, cutbacks by Government, rising unemployment and future interest rate rises could serve to halt the nascent price recovery and push prices down once more.

Certainly, there is little to support the view that property is particularly under-valued in either market.