What to Watch in the Markets in 2011

Year’s end is neither an end nor a beginning but a going on, with all the wisdom that experience can instill in us.

~ Hal Borland

Objectively, there’s nothing magical about the beginning of a New Year. Midnight on January 1st is just another minute. But it does serve as a reminder to us that time marches on and that it’s a good idea to look at where we’ve been and where we might be going. We’ve been doing that this week, and we finish off today by zooming in on some more specific themes that will continue to evolve in 2011. Many of these themes will serve as hinges for the markets and the economy: a swing in one direction is bullish, while a move the other way would be bearish. (You might want to read Part I of this analysis as well: 2011 What Ifs: Overview.)

China

It would be difficult to talk about the future of the global economy – next year, or for many years to come – without beginning with China. When China recently announced that it would be buying Spanish debt, the Euro rallied. Although their recent interest rate boost didn’t move the markets much, that could have been because they chose to do it on Christmas Day. Still, China can’t save all of its big news for holidays where no one is paying attention, so I’m sure each of its moves will continue to be dissected by market participants in 2011.

David Rosenberg believes that China is overheating, but lots of other analysts are confident that China can engineer a soft landing. If they can manage to cool their economy without sending it into a tailspin while simultaneously supporting the debt-laden countries of the world, that would be very bullish. If, however, there are any glitches on either front, such as runaway inflation, civil unrest, a real estate collapse, or an unstoppable debt crisis, things could turn ugly very quickly.

I covered the bull and bear cases on China late last year, wondering in the end whether China is different. After all of that research, I’m still not sure exactly how this will play out. Many believe China could see a correction in the near term, but that its long-term growth prospects are undeniable. I suppose that sums up my basic view as well as any.

Debt

The debt issues from last year are still with us. In fact, they’ve gotten worse. More and more countries in Europe have very high levels of debt and the fiscal problems throughout the globe have only deteriorated thanks to repeated bank bailouts and continued spending. Société Générale had an interesting graphic on global leverage that showed the U.S. and U.K. in very precarious positions.

The bifurcation we discussed on Wednesday is very apparent on the debt front, both at the sovereign and personal level. Surplus countries and their citizens tend to be saddled with less debt and the personal savings rate for those countries is generally higher. On the other hand, countries with high deficits tend to have a high (and increasing) amount of debt and lower savings rates. (Japan may be an exception, with personal savings rates that remain quite high even as public debt balloons.) Even Canada, which weathered the recent economic storm comparatively well, has seen its central bank chief repeatedly warn citizens to reduce their very high personal debt levels in preparation for higher interest rates.

Again, these problems were with us throughout 2010. They did cause some tremors in the market, but were largely ignored in the end. The hope is that the stimulative efforts of governments will eventually take hold and allow for self-sustaining economic growth. If that happens, we may be able to buy the time we need to restructure the mountains of debt out there. If it doesn’t happen in time, the debt restructuring will still take place, but it could turn quite disorderly.

Currency Wars

One of the effects of high sovereign debt levels is that the affected countries would like to devalue their currencies in order to reduce the value of their debts. The problem is that everyone can’t do it at once without creating tremendous instability in the global financial markets. Niels Jensen cited this type of “beggar thy neighbour” mindset as one of his dirty dozen risk factors for 2011.

In 2010, we saw glimpses of trade protectionism and currency jawboning around the globe. So far, it hasn’t caused much more than a lot of water cooler “what if” discussions. But if market participants start to feel like the jawboning is going to convert to real actions, we could be in for a bumpy ride.

Bonds

Bonds rose through the middle of 2010, but experienced quite a sell-off in the last quarter of the year. That had market participants scratching their heads, since QE was supposed to keep rates low. The size and swiftness of the move sparked a great debate about the prospect of a bond bubble. Some argued that the rise in yields reflected an improving economy while others warned that the bond vigilantes had finally decided to draw a line in the sand, punishing countries with poor fiscal practices.

So far, the fall in bond prices has been positive for equities, but many worry that it reflects some unsustainable economic trends and could turn disorderly in a hurry. Jonathan Wellum had this to say in an interview posted at Investing Thesis in November:

There is no way we can expect to maintain interest rates at the current levels throughout North America. Eventually, interest rates will reflect the underlying risks in our economy which have never been higher, post World War II. The super low rates we are experiencing now are an artificial construct forced on us by the central banks. This artificiality is leading to another bubble, a debt bubble that when it breaks will shake the foundation of our global economy.

There’s one factor that may come out of left field in 2011 to touch off a debt crisis. Ironically, economic improvement could serve as the trigger that sends bond yields above their tipping point, setting off an avalanche on the mountain of global debt. Even a relatively small, but sustained increase in interest rates could seriously hamper the ability of sovereigns and consumers to service their debt obligations.

Housing and Municipal Bonds

The U.S. housing market continues to be plagued by declining prices and increasing scandals. It has yet to show any signs of recovery, and may even be in the process of a fresh dip. It will likely be important to watch how the fraudclosure drama plays out in the United States, as some think investors are underestimating the severity of the housing problem. So far, the authorities are more interested in insider trading rings than bank fraud, but that could change with some timely reporting and the public outrage that would likely ensue.

The housing markets in Canada and Australia did not suffer throughout the recession, but Mike Shedlock thinks they are bubbles that could burst in 2011. He also thinks we could see China overheat and some municipal bankruptcies in the United States. Municipal bonds, normally a safe and sleepy asset class, have made it onto a lot of “What to Watch in 2011″ lists.

Commodities

I’ll be brief on commodities as I’m running out of room and what happens with commodities will depend on many of the factors mentioned above. It’s worth noting that, while many bullish analysts think energy and agricultural commodities will continue to rise in 2011, a lot of the same experts are somewhat bearish on gold. Doug Kass predicted a significant pullback in gold for the coming year in his 15 Surprises for 2011. Still, the $250 correction he’s calling for would leave gold at levels that many said would never be attained only a few years ago.

Final Thoughts and a Dark Horse

I would just add one final thing to keep your eye on. We have been putting off major restructuring in pension plans globally for many years now. Demographics mean that we will have fewer people paying into pension plans than collecting on them. A lot of pension plans are already underfunded. Further, many of these plans depend on models that include annual returns in the neighbourhood of 7%. We all know that has not been a reality for many years now.

If the markets have another accident, the math looks even worse. Either way, many are not saving enough for retirement and that will have consequences at some point. This is yet another financial can that we can’t afford to kick down the road any longer. So that’s my dark horse. It may not be a factor in 2011, but it should be on the agenda for all of us.

Trying to predict the future can be fun, like the childhood fortune telling game in the photo above. Unfortunately, it’s usually not any more accurate than the silly phrases your friend wrote on those paper sections. The continuing divergences in the global economy mean we’re likely in for another highly unpredictable year in the markets. There will be money to be made on the long and the short side for nimble traders, but long term investors may find the market action a bit frustrating. It’s always true that anything can happen. Somehow, though, it seems a little more true these days.