When the wheels come off...

As we've rolled into 2010, the annual plethora of analyst predictions for the year ahead have been furnishing the financial pages and beyond. At different times this Nostradamus-like process is probably pretty straightforward, I would think, though often in those "dull" times not particularly exciting - unemployment to rise or fall by 0.2%, and interest rates to remain within a 0.5% boundary and other such mundane predictions. Typically, 12 months forward those predictions are long forgotten by those who were wrong (about 90%) and hailed (by themselves) as god-like foresight by those who were right-ish (the other 10%). The low level of effectiveness is surprising in the dull times - as the saying goes, even a stopped clock is right twice a day.

This year, what's been noticeable is that there is a disturbing level of optimism amongst many of the world's financial prophets - a lot of which, to be fair, is entirely understandable. It requires little genius for example, to see that the exceptional fiscal and monetary measures adopted worldwide in response to the recent crisis do guarantee a return to global growth in 2010. Financial markets are perhaps less clear - for much of the past year most asset classes rose in sync before wobbling when confronted with sovereign debt issues in Dubai and Greece in particular. Yet before taking cover in the face of escalating risk, investors have to recognise one inescapable reality: as long as exceptional monetary measures remain, the penalty for holding cash as opposed to financial assets, will be quite penal in relative terms.

This is a truism that I was at pains to acknowledge through 2009, and remain at pains to acknowledge for the coming year. There is more than a tinge of bitterness about the fact that I missed out on the bumper returns of 2009, because I couldn't get my head around how long the "artificial" government supports would remain in place. Sour grapes I know!

As I've written before, in effect we have been solving one short term issue with more of the stuff that caused cracks in the first place - too much debt. Saying that is not rocket science. Asset prices have increased across the board because of "quantitative easing" and near zero interest rates. Consequently we have created a wall of money that is chasing all assets around the financial system. With a bit of simple economics, we arrive at higher asset prices across the spectrum. Simples.

Where my burning issue lies is that all of this must have some long term economic consequences, which the equity analysts (in particular) seem keen to ignore, by and large. The excess liquidity isn't going to heal the economic system for the long term. While the short term benefits are significant (which makes the analysts right over that time period) there is a real risk that the financial system will become addicted to leverage in an even more profound and destructive way than we were when Lehman Brothers went bankrupt in 2008. I remain, to my own short-term detriment, of the Warren Buffett view that "when you combine ignorance and leverage, you get some pretty interesting results."

When the financial crisis struck - we were warned of excessive leverage in the system, and the willingness of those who couldn't afford it to take on more and more debt. A free-functioning economic system is meant to reward good decision making, and punish the bad - a form of economic Darwinism. So far not enough "natural selection" has been allowed to occur. I remain rooted to the spot and intent on waiting against the current tide for the opportunities that must come when the stabiliser wheels are removed from the financial bike. In the short term it is maddening to think that public policy is actually re-emphasising the importance of debt to finance consumer spending in our economies. It's not unlike a doctor prescribing crack to beat a crack habit - makes the patient feel good in the short term, but not really viable for the future.

The judgements of the world's analysts should be harder than ever this year, but you would be unlikely to hear such talk. Neither credit nor equity markets offer bargains. Commodities look even more dangerous - given that they have soared in price when the global economy has been going the other way - it's clear to me that speculation about future growth has created a bubble. The big question for commodities, as for all risky assets, is what happens when economists try to forecast growth in the world post fiscal and monetary easing. Will the private sector pick up the baton to the extent required?

Many equity analysts seem pretty chilled about this point, but I'm not sure why. The valuations they have been applying to corporate earnings rely heavily on a robust recovery. Banks - the creditors to these companies - remain undercapitalised and incapable of providing sufficient credit to sustain a "normal" recovery. In the world's deficit countries, households and corporations are rebuilding their balance sheets, and consequently investment remains low because of excess capacity. When we arrive at the end of the fiscal and monetary shennanigans, the global economy's former big borrowers and consumers (UK, US etc.) will have to rely on increasing exports for economic growth, but it's questionable as to where the buyers will come from. Japan, China and Germany have the highest concentrations of surplus "savers", but the likelihood of a cultural/ structural shift towards a greater reliance on consumption to drive demand is unlikely. Either way, I hope I'm prepared.

So, I've proven to myself through 2009 that I have an appalling sense of market timing. In hindsight the incredible stimuli that have surrounded the financial system were bound to lift all risky assets. I don't regret sitting on the sidelines to the extent I have done, because as hard as I tried I could never rationalise the market situation - all apart from the fact that my wife wouldn't have allowed me to! I suspect that we will have opportunities going forward as the governments of the world contemplate their exit strategies from their ongoing participation in not-so-free markets. I'm firmly of the view that when these stabiliser wheels are removed then we will have some real problems - and if they are not removed in the short term, then we will have a whole other set of problems.