Another horror year for contrarian investors?

At the beginning of 2011, consensus investor views bear a remarkable resemblance to those at the start of 2010: equities are the place to be and government bonds will yield an unexciting return at best. Last year the consensus proved right, even if most investors had to wait till the last quarter of the year to see their expectations fulfilled. It did not pay to be a contrarian in 2010. Will that be different in 2011?

At the moment the investment skies appear blue. Economic growth and corporate earnings in the developed world are surprising on the upside. Inflation is only an issue in some fast growing emerging markets and appears to be countered adequately by local policy makers. Their measures to slow growth may temporarily reduce the attractiveness of some emerging markets for equity investors, but this fact may be balanced by an increased appetite for some developed markets. After all, the printing press is still running in the US, at least until July. And in Europe the recovery of the all important German economy is surprising even the biggest optimist. The positive consensus expectation for equity markets is therefore understandable.

However, contrarians will point to the fact that in this third year of the recovery the risks for earnings disappointments increase. They will also point to the risks of the battle against inflation in emerging markets, the lack of recovery in employment and housing in the US, and of course the ongoing sovereign debt crisis in the eurozone. In our view, these are indeed valid reasons to expect volatility. . . but they do not justify a negative outlook for equities!

After all, the inflation issue in emerging markets is being countered and the jobless recovery in the US helps to keep policy accommodative. The biggest risk remains the eurozone crisis. We are quite convinced that the eurozone will remain intact in its current form. There is simply no alternative, given the huge financial interdependencies. In the course of 2011, eurozone policy makers are likely to make sure that further speculative attacks will be discouraged.

Any solution to the eurozone crisis will require further money transfers from north to south. This could be done by vastly increasing the size of the European Financial Stability Facility to well in excess of 1000 bln euros, even if such an act could raise suspicion that there are more skeletons in the closet. Another possibility is the large scale issuance of Eurobonds, which would decrease borrowing costs for the south, but increase them somewhat for the north. Both of these options are viable answers to the eurocrisis but would take time be agreed upon and to implement. In the mean time, the ECB will have to keep buying time. In this respect, a further extension of unlimited liquidity provision by the ECB to the banking system and more buying of bonds are a very real possibility.

Currently, we do not think that it makes sense for investors to be contrarian by selling equities and buying government bonds. However, this may change later this year. As the year progresses the risk of earnings disappointments will increase and the policy stimulus may fade. It is questionable whether quantitative easing (printing money) in the US will continue beyond July. It is also questionable if western central banks will keep rates at historically low levels for the full year. We think the ECB may be the first to raise rates, possibly already late this year. Conclusion: the best equity returns in 2011 may very well be made in the first half.