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Tuesday, January 19, 2010

Four things to worry in 2010

Among those, what worries me most is bank's balance sheet.

Few would have dared predict 12 months ago that markets would rebound so strongly. Most major stock markets ended 2009 at or around their highs for the year. Both the S&P 500 and FTSE Eurotop 100 rallied 24% over the year, while corporate-bond markets and commodities also staged rallies.

But what about 2010? Most economists expect the recovery to be sustained, albeit with fewer opportunities, to make significant gains. But any optimism needs to be tempered by caution. The global economy still is exposed to significant risks. Here are four:

Sovereign risk: The Dubai World debt default and Greek fiscal crisis were reminders that vast amounts of debt remain outstanding, with implicit or explicit guarantees from friendly sovereign nations. Will those nations be willing to stand behind the debt? The market is betting Abu Dhabi will bail out Dubai and the euro zone won't allow any of its members to default, even if the pain spreads to other highly indebted states such as Ireland and Spain. A more-pressing case may be the U.K., whose fiscal position is the worst in the industrialized world and which enjoys no implicit guarantee.

[RISKHERD]

Exit strategies: The Federal Reserve and European Central Bank both have set out plans to withdraw much of the emergency liquidity supplied during the crisis. The Bank of England also is expected to stop buying U.K. government bonds in February. That could pave the way for considerable bond-market volatility, because central-bank programs have helped push down yields across all asset classes. Investors should be wary of parallels with 1994, when an unexpected U.S. interest-rate increase triggered a bond-market rout. On that score, they should be watching for any sniff of rising inflation.

Slow growth: Much of the optimism in the markets is based on expectations that global growth will be robust enough to speed up the process of deleveraging among overindebted Western economies. One risk to this outlook is that a combination of fiscal tightening and monetary-policy exit strategies leads to a "double-dip" recession. Another is that U.S. unemployment will be slow to fall while European unemployment continues to rise, leading to weak consumer demand. A slower-than-expected recovery would lead to higher bank-loan impairments and put more pressure on government fiscal deficits.

Bank balance sheets: The global banking system is in better health than a year ago, bolstered by large injections of equity and strong earnings. But trading desks could be vulnerable to any asset-price corrections. And doubts remain whether banks are facing up to the full extent of losses on loan books. The practice of "amend, extend and pretend," particularly in relation to commercial property, may be concealing the true scale of bad debts. A sharp rise in bond-market yields also would put pressure on bank-funding costs.While 2010 is unlikely to bring anything like this year's gut-wrenching volatility, investors shouldn't expect it all to be plain sailing.