THE BLOG

A New Year for Stock Markets

12/31/2011 09:45 EST | Updated 02/29/2012 05:12 EST
AP

Depending on one's perspective, 2011 will be viewed as disappointing, bordering on terrible; or, it will be looked back on as a year where we should be thankful. True enough. Stock markets experienced their wildest ride since the beginning of 2009 and shockwaves were felt from three global epicentres -- Washington, Japan, and Europe.

In two of these focal points, investors were brought face to face (finally) with the reality that solving the 2007-08 housing and credit crisis merely kicked the can down the road to the next bus stop; that being government debt.

Despite a somewhat more pleasing December, Europe's equity markets ended the year with heavy losses, ranging from roughly an almost miniscule five per cent loss in London to a 60 per cent plunge in the Athens ASE 20 index. In the case of the latter, the index is now less than a tenth of where it stood at its peak in November 2007.

If we adjust for volatility, the pain inflicted on portfolios heavily weighted in Europe was significantly worse. Where traditionally we would expect bond markets in the afflicted regions to strengthen in the face of deteriorating economic and equity conditions, this obviously wasn't true for Europe's periphery, and that includes Italy.

Bonds in the core did, however, offer protection albeit with some tension. German 10-year yields closed the year well below two per cent -- a full percent lower than where they started in 2011 -- and the UK 10-year gilt slipped below two per cent in the last week of trading. And if you think that's incredible, consider that the 10-year Swiss benchmark bond is nearing 0.5 per cent.

Even for this traditionally ultra-low yielding nation, the developments of 2011 have smashed even the wildest forecasts. Yet the most mind-bending result of the year for most investors was how U.S. government bond yields could reach record lows in an environment of rating agency downgrades and warnings. Finishing 2011 at 1.90 per cent may not have been the lowest the 10-year Treasury note saw last year, but it wasn't far off.

Let's not forget that Canada wasn't excluded from the fixed income party in 2011, with Ottawa's own 10-year yield closing below the two per cent mark. So, as we break out the champagne this weekend the big question for investors is what kind of hangover awaits the bond market in 2012, if any.

Most central banks have provided clear guidance that they will maintain sufficient loose liquidity in the coming year to prevent further economic slippage and to provide a buffer zone for bonds as fiscal restructuring measures are enacted. Such measures will carry a heavy growth price tag in Europe, but we'll see dents to North America's trajectory on deficit control initiatives.

Aside from the obvious moral hazard risk that central banks have created by this fixation with near-zero short-term funding, certain economic realities will return and that includes inflation. While I still don't expect global inflation to be a problem in the near-term, only a drunken central banker would believe there to be no risk at all.

Consider the fact that U.S. Consumer Price Index (CPI) inflation has spent the last three quarters north of three per cent and a disturbing upward tendency since the 2009 recession trough. Europe's inflation rate also trended higher through 2011, hitting a three-year high of three per cent in the past quarter.

Canada has had its own experience of above-target inflation, with the rate peaking at 3.7 per cent in May but still holding close to three per cent in the final months of the year. Bottom line, central banks will not be able to ignore inflation risk much longer barring an outright global economic recession, and at some point this has to be priced into bond markets on both sides of the pond.

My New Year's message is for investors to be as acutely aware of what is going on in their fixed income portfolios as what their beloved stocks are doing.

I expect equity markets, especially in Europe, to deliver better results in 2012 than the year we leave behind, but bond markets could run in the opposite direction just the same.