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2010 Outlook

Frank Koster
Chief Investment Officer

Just over a year ago, the 10-year Treasury was flirting with a 2% yield and investor enthusiasm for anything other than Treasuries was virtually non-existent. The S&P 500 had returned -37% for the calendar year 2008 and fell even lower through the first quarter of 2009. The global economy was going through a massive deleveraging, confidence in the financial system was at a nadir, and the possibility of the next Great Depression was being widely discussed. However, the catalysts to the mayhem of that period have been well documented. We would like to use this opportunity to discuss the progress that has been made since that bleak period, and more importantly, what we can expect in the year to come.

Central banks and governments around the globe have implemented unprecedented monetary and fiscal easing policies to soften the blow of pervasive deleveraging in the private sector. These measures began to generate their desired effects over the course of 2009, as evidenced by improved valuations across the risk spectrum, dramatically improved liquidity in the structured product universe, and apparent bottoming in such key series as home prices, initial unemployment claims, and auto sales, among others. We had two quarters of positive GDP growth during the second half of 2009, and we are estimating GDP growth for 2010 to be greater than 3%. Despite this overall improvement, however, the economy spent 2009 on life support and remains in a fragile and transitional phase as we enter the new year. A key concern for 2010 is whether the economy can continue to survive as its support system is gradually withdrawn.

It is intuitive to think that interest rates should rise in the scenario of a self-sustaining and slowly recovering economy (particularly on the short end of the spectrum, where the fed funds rate is effectively 0% and the 2-year Treasury is yielding a parsimonious 1%), but the Fed may delay this inevitable outcome. Given what has transpired in financial markets in conjunction with the dramatic policy responses put into place, the Fed is essentially out of ammunition. Consequently, the Fed will want to be absolutely certain that the economy is getting around of its own volition before elevating the fed funds rate. While rates will likely be higher a year from now, we expect that this time, the path to higher rates will occur over a more protracted period than during prior economic recovery cycles.

We believe risk assets will generally be rewarded in 2010, given our view of a stabilizing and improving economy, exceptionally high levels of liquidity, and normalizing capital markets. Both investment-grade and high-yield credit should do well, though the spread tightening that has already transpired in these sectors makes it mathematically impossible for them to perform as well as they did in 2009. Nevertheless, we believe that solid positive excess returns for the year are likely. (Historically, the corporate bond market has done exceptionally well in the periods immediately following a recession and has posted several subsequent years of less-spectacular, but still strong, returns—we expect the current cycle to repeat this past performance.) One caveat is that, because the market has improved from the extremely oversold conditions of earlier in the year, it will be important to conduct intensive, bottom-up fundamental research on individual credits. Significant differentials between winners and losers are to be expected in this transitional environment.

The mortgage market, meanwhile, was at the epicenter of the financial crisis and has necessarily played a critical role in the recovery. Washington's initiatives in this sector have been focused on providing liquidity and have taken many forms, from insuring leverage secured by outstanding mortgages, to loan modification programs and outright purchases of newly created agency mortgages (over $1 trillion to date). These programs have been largely effective in supporting the housing market, with a collateral effect of extremely rich valuations across the agency mortgage sector. The majority of these support initiatives are scheduled to expire over the next several months, and whether the mortgage market can stand on its own remains to be seen. Nevertheless, we are optimistic that the recovery will continue as long as market interest rates do not rise too much or too quickly.

We expect the economy to lurch through this period because many headwinds still remain. Mortgages will have to cheapen as support programs expire, which will cause financing rates for homeowners to increase. This will retard the recovery in home prices. Residential delinquency rates are still increasing (albeit at a decreasing rate) which provides an additional headwind, as does the inventory of foreclosed and unsold homes. In the meantime, the commercial real estate market has been receiving a lot of negative press lately, and delinquency rates are likely to continue to rise there as well. These factors will undoubtedly continue to delay economic progress, but, as the old adage goes, bull markets climb a wall of worry.

Overall, we believe that risk will be broadly rewarded in 2010, perhaps not in spectacular fashion, but in solid, positive returns. We also expect corporate credit to fare well in the year ahead, though intensive fundamental research will be critical to success in this sector. In the context of an improving economy and a contained (though upward-trending) interest rate environment, investors should be relatively happy a year from now, provided they are willing to take their money from underneath the mattress and apply it to capital markets today.