In many ways, the tale of the market for 2009 was of tremendous momentum, first down for economies and capital markets followed from March 2009 by closely correlated upside in capital markets generally but selectively in economies. In an ongoing continuum of budgets from Japan in December 2009 with its eye-popping potential for debt close to twice GDP, that released by the administration on February 1, 2010 for the United States makes for somber reading at $3.8 trillion but with $ 1.6 trillion in deficits for 2010 and $ 700 billion even in 2013. It is somber in that notwithstanding their ideologically commitment to smaller government, in their time, even U.S. President Reagan and British Prime Minister Thatcher were constrained to slowing the rate of growth of government We have been focusing on the aspect of risk tweaking the market’s tale that appears resting on government largesse. In raising the theme of re-evaluation of a different type of risk from securitization hubris that proved to be the undoing of 2006/7, we refer to our notes as recent as that of December 19, 2009 (Miles to Go and Promises to keep, still) and January 24, 2010 ( Reset amidst Yin and Yang of Flows and Fundamentals) as well as our start- of -year January 4, 2010 note with but one resolution (Wary of Socialization of Capitalism) over laundry lists favored by others. Portfolio mix needs to be less concerned about price and more focused on value. Even as economies and operations recover, we believe markets in early 2010 are already changing away from momentum and towards discrimination based on quality of delivery for companies and governments alike. In fixed income for instance, the issue with Greece is less about breast beating over the European Union and more whether the sharp rise in bond yields of Greece (now 6.6% up 75 basis points since year end 2009) are anomalous or instead harbinger of things to come even for advanced economies. Similarly in equities while much is being made about individual stocks not responding to strong Q4/2009 earnings momentum, the tweak may now lie with the appropriate level for their valuation. As benchmarks, we maintain neutrality to be 5% yield for U.S. 10 year T-Notes and 15-18x P/E for the S&P 500. We elaborate.

A more discriminatory environment that a valuation focus entails may already be unfolding from that driven by momentum. Below, we reproduce charts from the IMF and the U.S. Congressional Budget Office who (along with the Bank for International Settlements) present some of the more comprehensive assessments of the financial environment at any point. It is clear from projections as well as anecdotal evidence that global bottoming and recovery may be unfolding but also that budget shortfalls have expanded to major levels in total as well as relative to revenues in major advanced countries like the United States. At the same time, central bank freedom to maneuver has come under scrutiny. While faster growing countries like India and China have recently tightened some policy in the latter by leaning against bank lending and in the former by formally raising capital reserve ratios, even they have been reluctant to initiate rate increases. In the advanced economies, similar signals appear absent on policy flexibility even for the future as seen not just in the January 27,2010 FOMC statement from the U.S. Federal Reserve but also from the February 2, 2010 decision by the Reserve Bank of Australia not to raise rates at this stage. Historically, budget deficits are difficult to reduce, obfuscation takes over in the form of structural and cyclical arguments, as have started today-- vigilance is required. Albeit for reasons then related to underestimation of inflation and with fixed income following equity valuation, in the late 1970s/early 1980s, vigilante behavior had its epicenter in the major advanced country publicly traded fixed income markets. Currently, with pricing in the publicly traded advanced country fixed income markets having become embroiled in the quantitative ease programs of the major central banks and with junk bond yields having dropped on precipitous momentum to levels that just a few quarters ago would have been considered the realm of sovereign debt, vigilante behavior may now be re-asserting itself a la the 1980s but now in emerging country sovereign debt. Also, in IMF Working Paper No. 10/26 dated January 29,2010 (http://www.imf.org/external/pubs/ft/wp/2010/wp1026.pdf) and titled International Pricing of Emerging Market Corporate Debt: Does the Corporate Matter?, authors S. Keller and A. Mody argue that except during periods of financial crisis, firm level information becomes important even in emerging economies. In the form of increased discrimination in funding and yield increases in sovereign debt of smaller countries, developments have in fact been coalescing for much longer than generally accepted. It arguably surfaced in the funding message delivered by China to Pakistan in its initial foray ahead of its $5 billion re-funding in April 2009. We believe also that for Dubai, it may have been delivered implicitly by Abu Dhabi, notwithstanding its purported $10 billion back stop in December 2009. Much is currently being made of the funding responsibility of the major European countries in the interest of Euro stability but Europe for too long maintained the fiction of delivering Eurozone benefits for late ascending countries including Greece, Spain, Portugal but also Ireland and others without enforcing the required delivery on commitments of domestic restructuring. Greek bonds now with a yield of 6.6% are now closer to the 6.7% average reported by the Wall street Journal (February 1,2010) for a blend of emerging countries. It is hard to argue in light of European growth and deficit prospects even within the European Union that Greece represents a stronger credit than emerging countries in aggregate. Momentum may have overwhelmed such arguments earlier but now the real message of the weaker sovereign credits may be that vigilante behavior is returning now from that portal. The next issue could very well be that time is running out on expectations that suffering Japanese investors will continue to backstop low rate financing of government and banks that started in the 1990s. Also underscored is the potential for a progressive return to neutrality in the major advanced country government bond markets to levels that we benchmark closer to 5% for 10 year U.S. T-Notes (compared to present yields closer to 3.7%).

In equities, we also believe that going forward, greater discrimination as well as more focus on valuation is likely to play a role. There appears little doubt that both in the sell-off into early March 2009 and the recoup thereafter, momentum played a major role whether looked at from the perspective of close global correlations or from the perspective of low quality participating in equity leadership. It would appear that considerable confidence was being placed on the efficacy of government largesse. However, we do not regard such dependence on government to be normal behavior for capital markets, especially in equities. We would expect more favor for the efficacy of corporate performance and delivery in the form of operational quality as well as financial strength. The last cycle that was based on concept for secular growth without government largesse was that in information technology which after early 2000 was largely determined by more prosaic developments in the form of restructuring which continue until today. We would not expect financial shock to distract from the importance of quality of delivery bt to add to it as this cycle continues to unfold. In fact, in another interesting IMF Working Paper No. 10/23 dated January 1, 2010 (http://www.imf.org/external/pubs/ft/wp/2010/wp1023.pdf) : Financial Shocks and TFP Growth, authors M. Estevão and T. Severo find that when considering industries' dependence on external funding for over 31 industries in Canada and the United States, increases in the cost of funds have a negative impact on TFP growth with financial shocks distorting factor allocations even across firms even within an industry and with decline in productivity growth accounting for negative impact of funding costs on output. At the macro level during the turmoil in global economies during the credit crunch into 2009 and arguably even during the run-up to global growth peaking into 2007, much was made of leadership from the BRIC (Brazil, Russia, China and India) countries. Now as global recovery demonstrates early signs of resurrection, there has been a tendency to make similar such broad assertions. If we are correct in expecting a more discriminatory environment after financial shock, some other considerations apply. For instance, while China and India have clearly demonstrated substantive growth and possess the stability of large populations, when it comes to economic growth, corporate governance and political transparency we would submit that the ASEAN countries offer substantial advantages over Russia with both Australia and Canada offering alternatives if resource exposure were to be the criterion. Separately, after several quarters of downward earnings momentum, Q4/2009 earnings reports have had upside momentum that has been substantive at for instance above 200% for the S&P 500. However, if valuation were becoming an increased criterion alongside revenue growth potential, more discrimination would be expected than simple relief over earnings gain derived from cost cutting. More to the point, while equities did lead fixed income in valuation first lower based on deteriorating quality in the inflation angst of the late 1970s and then led higher in the late 1980s, currently and for reasons to do with quality of delivery during slower growth and lesser credit, it is likely that the valuation transmission line from emerging country sovereign debt yields, upward re-adjustment could be harbinger of not just yield increases advanced country government public debt but also into greater bifurcation in equity valuation. We believe P/E neutrality to lie as benchmark in the 15-18x P/E range for the S&P 500 with lesser dependence on earnings momentum for stock performance.

Figure 8. Total Revenues and Outlays of U.S. Government
(Percentage of gross domestic product)

Source: U.S. Congressional Budget Office.