The world has evolved into a two speed economy. On one side is the G7, stymied by the financial crisis, deleveraging and disinflation, slowly clawing its way back to trend growth and requiring additional policy action and stimulus. On the other are the Emerging Markets, enjoying a robust recovery, rising asset prices, accelerating business activity and budding inflationary pressures while trying to prevent the formation of new asset bubbles. Thus:

  1. US stock markets may lead the rest of the world because the economic revival is still at an early stage. There has been a phenomenal profit recovery and Fed policy is not shifting – thus the stock market is in a sweet spot
  2. The euro area fixed income markets will offer many interesting opportunities as their debt crisis evolves
  3. Unless a bubble forms, Chinese and emerging market equity performance will probably lag until economic conditions cool; but their currencies will outperform

As global growth surprises to the upside and food & energy prices remain lofty, a mini inflation scare is hitting bonds similar to early 2010. None-the-less, inflation fears are overdone in a world of high unemployment and output gaps. Until wage growth accelerates, it is difficult to envision a sustained rise in core inflation. Therefore, central banks will not tighten soon.

Demand for risky assets will remain strong. Congruent with our closed-end fund positions, we favor CMBS, investment grade, high yield and municipal bonds.

  • Investment grade and high yield debt has more room to tighten versus Treasuries, thus creating opportunities for outperformance
  • Munis have been hit by headline risk and mutual fund withdrawals, but governors and legislators are actively reforming budgets and have the power of the purse

In addition, US Equities should perform well long-term, although near-term valuations may be a bit stretched. We ended the year positive and may add some additional risk at the onset of the new year.

We are concerned about the following:

  1. Can the Euro area crisis be contained? It appears Portugal and Spain are next. Will the European Central bank act quickly and will it have the resolve the Fed had during the US banking crisis?
  2. Can the recovery in the US be self-sustaining after the stimulus expires? How long will it take to get sustainable 4% grow in GDP? Goldman thinks maybe 5 years! Frankly, we’d be okay with 2.5% to 3.5%, which would be supportive of high yield.
  3. Will the Fed fulfill its intended Quantitative Easing 2 (QE2) purchase of $600 billion US Treasuries by June 30 or will it succumb to political pressures? If economic conditions improve, then the end of QE2 means yields will be priced in by late in the first quarter. If economic data disappoints, then the end of QE2 means the loss of a substantial market support facility and a potential decline in yields as inflation concerns dissipate.
  4. How will the markets react, in the future, in light of the policy distortions (US Government owning corporations and European Commission promoting the notion that senior bank debt must participate in restructurings allowing lower portions of the capital structure to survive) and the financial imbalances that occurred during the last 3 years?

In general, even though we are positive, there are many big picture items to monitor. We wish you a healthy and prosperous 2011 and thank you for your continued vote of confidence in us.

Michael Ashley Schulman, CFA
Managing Director
Hollencrest Capital Management