Market Outlook | December 2010

iShares Market Perspectives

2011 Outlook Executive Summary

“Doubt is uncomfortable, certainty is ridiculous” - Voltaire
Four Scenarios to Watch
“Prediction is very difficult, especially about the future” - Niels Bohr
in the Coming Year
While 2010 was a respectable year, and in a few instances an excellent
one, for most financial markets, it came with the sobering realization
Russ Koesterich, Managing Director, that many of the global imbalances investors thought were behind
iShares Chief Investment Strategist us remain, albeit in a slightly altered form. Which leaves the question;
will 2011 be the year when these imbalances re-erupt? We believe
the answer is no, at least not during the next 12 months.
For 2011, we believe the overall global economic environment is likely
to remain conducive for risky assets. We would expect developed
markets to stage steady, yet uninspiring recovery. Growth should
be subdued but positive, with inflation remaining low. While rates
will rise over time, given low inflation and anemic demand for capital
from everyone except sovereign borrowers, we believe bond markets
will remain stable enough so as not to derail the equity market rally.
In emerging markets, we would continue to expect outsized growth,
although that growth is likely to slow as emerging market central
banks wrestle with inflationary pressures.
For investors, this means considering an overweight to equities and
continued exposure to commodities, particularly the more cyclically
oriented ones. Within credit, investors should consider overweighting
corporate credit versus sovereign.
While cyclical factors should support financial markets for another
year, to be clear we don’t believe that the market’s bottom in 2009
marked the beginning of a new secular bull market. The debt problems
that derailed the global economy in 2007 are largely still present; they
have simply morphed from the private to the public balance sheet.
Government unwillingness to address these issues, particularly in the
US, leaves both equities and bond markets vulnerable in the long-term
to wrenching fiscal austerity, unexpected inflation, or potentially both.
Fortunately, that pending crisis looks like it can be postponed for
at least another year.
An Age of Volatility continued strong economic growth. All things considered, not
A little over three years ago, the Dow Industrials hit an all-time a bad environment for global equity markets.
high and the list of established Wall Street firms still included That said, given the various risks in the current environment, we want
Lehman Brothers, Bear Stearns, and Merrill Lynch. In the summer to consider the alternative scenarios as well. Investors must always
of 2008, most financial participants believed the worst of the ask themselves one question whenever they commit money: what
subprime crisis had already been experienced, world equity markets will I do if I’m wrong? It is in that spirit that we offer the first iShares
had recovered, and the Fed was grappling with the highest inflation Investment Strategy Scenario Analysis (ISSA).
in decades. A little over a year ago, financial leaders struggled to
Our goal in this piece is to lay out the possible paths for economies and
prevent what seemed like an inevitable slide toward the first global
financial markets over the next 12 months, handicap the odds of each
depression in 80 years.
scenario, enumerate the key factors that can change those odds, and
Three years, three different market environments that experts were finally highlight investment strategies to consider in each environment.
mistakenly confident would continue. Extrapolating from the past is
a dangerous exercise during even the best and most stable of times.
During periods of volatility, it is simple folly. Today, it is no illusion that Scenario 1: Economic Decoupling
the world has become more volatile. Consider the following: 10-year
trailing US inflation volatility is at a 50+ year high, over the past two Developed markets muddle along while emerging
years dollar volatility is the highest on record, and gold prices are the markets continue to thrive
most volatile they have been since the mid-1980’s. Probability 55%
Nor is the recent volatility limited to financial markets. The volatility What it would look like
in asset prices has coincided with – or arguably been caused by –
Large developed countries – United States, most of Europe,
a similar spike in political instability. The US Congress has changed
and Japan – continue to limp along with uninspiring but improving
hands – Republican to Democrat and back again – twice in a six-year
recoveries. There will be some pockets of strength in developed
period. This has not happened since the 1950s. At the same time,
markets, notably commodity producing countries (Australia and
the US Federal Reserve has tripled the size of its balance sheet over
Canada), developed Asia (Hong Kong and Singapore), and potentially
the past thirty months, and plans to continue this exercise through
Germany. But by and large economic growth will remain sluggish
at least the middle of 2011. Outside of the United States, the tenure
in the developed world (1.5% to 2.5% GDP growth).
of Japanese prime ministers is starting to resemble that of Italian ones,
and an indecisive election in the United Kingdom has produced the Emerging markets slow modestly due to tighter monetary conditions
first coalition government since the Second World War. Politically, but achieve a soft landing. Effectively, the two-speed global economy
economically, and financially we are living in an age of renewed volatility. continues, with emerging markets maintaining their secular
advantage when it comes to economic growth and most developed
The one unqualified prediction that we will make for 2011 is that
markets weighed down by the 3 Ds: demand (or lack thereof),
economic and political volatility will continue. There are three reasons
debt, and demographics.
to believe this.
Why this scenario is likely or unlikely
First, many of the global imbalances which precipitated the previous
crisis are still around, albeit in slightly altered forms. Instead of a Developed markets are unlikely to reach their pre-crisis growth
pending subprime meltdown, we have the growing risk of sovereign levels given over-indebted consumers (in the United States and the
debt, which will be further exacerbated by aging populations and United Kingdom), sovereign debt issues (Europe), political uncertainty
unsustainable entitlement spending in much of the developed world. (United States and Japan), demographics (Japan and Europe), and
fiscal austerity (Europe). Furthermore, in contrast to late 2009 and
Second, the aftermath of financial bubbles is characterized by
the early part of 2010, the global economies will no longer benefit
slow, anemic recoveries in both economic growth and housing. Both
from the tailwind of an inventory restocking to support growth.
of these will contribute to overall economic and political volatility.
This still leaves open the question: will the recovery falter?
Finally, the ongoing economic shift from developing to emerging markets
Fortunately, there is sufficient evidence to suggest that while
will be a slow process, one that is likely to play out over decades.
the recovery is likely to remain anemic, it will nevertheless still
As it does, there are likely to be accompanying growing pains.
be a recovery. First, leading indicators suggest that for the first half
The good news for investors in the near term is that many of the of 2011, GDP growth should remain at around 1% to 2% in Europe
longer-term imbalances still facing the global economy are unlikely and 2% to 2.5% in the United States. Second, despite much agonizing
to erupt over the next 12 months. So our baseline view for 2011 over the deleveraging of the United States, the truth is that there
is a lackluster but steady recovery in the developed markets with is no deleveraging. While the US financial sector has significantly
continued low inflation. In the emerging markets, we would expect reduced its debt from the pre-crisis levels, overall US debt continues

2
to climb courtesy of federal deficit spending. The dirty little secret Investment strategy
is that despite the financial crisis, overall US non-financial debt has First, investors should look at raising their equity allocation and
climbed by nearly $4 trillion, or over 10%, since the end of 2007 (See lowering their fixed-income exposure. While the recovery will be
Chart 1). Finally, the extension of the Bush tax cuts and long-term weak it will be a recovery. Today, particularly in the United States,
unemployment benefits is unambiguously pro-cyclical. While adding fixed-income yields remain near record lows and real yields are also
to the country’s long term imbalances, i.e. the deficit, both measures close to their bottom. While equities are not as cheap as the 2009
will add to disposable income and by extension economic activity. bottom, they appear reasonably valued and should have room for
CHART 1 further multiple expansion.
Total US Non-Financial Debt Overall, US equity markets look well positioned for a good year.
Stocks in the United States will likely benefit from the low inflation/
40000
rate environment. Typically, US large caps trade with a multiple in the
35000 high teens when inflation and interest rates are this low. With the S&P
500 trading at 15x trailing earnings, there is room for modest multiple
Debt in $ Billions

30000 expansion in 2011.

25000 Beyond the broader US equity market, favor developed markets

and sectors with high exposure to emerging markets. In the United
20000
States this would include industrials, technology, and consumer
staples Outside the United States, attractive countries include
15000
Mar 00 Mar 03 Mar 06 Mar 09 Germany, smaller developed countries in Asia such as Singapore,
and commodity producing countries such as Australia and Canada
Source: Bloomberg
(of the two, right now Australia looks to be the better value).
Factors to watch Commodities should continue to do well in 2011, but investors
should favor those commodities that are more tied to emerging
For most developed markets (Australia is one exception) the primary
market growth, such as energy and industrial metals.
risk next year remains further economic deceleration, not accelerating
inflation. With that in mind, watch the leading economic indicators –
which do in fact lead GDP over the next one to two quarters. In the
Scenario 2: Global Double Dip
United States, the best measure of leading economic activity has
been the Chicago Fed National Activity Index (CFNAI). The CFNAI
Probability 25%
explains roughly 45% of the variation in GDP over the next quarter.
Currently, it is signaling that US growth in early 2011 should be What it would look like
around 2.5%. A drop in the CFNAI to below –1 would significantly The global economic rebound falters, developed countries slip back
raise the risk of a double dip. into a recession, while emerging markets experience sharply slower
In Europe pay attention to the German IFO Survey, which not only leads growth. Equities and commodities trade lower while the dollar and
German GDP but overall European economic activity as well. Also, pay US Treasuries rally.
careful attention to fiscal policy; too much near-term austerity raises Most likely this scenario would be brought about by an exogenous
the risk of pushing most of Europe back into recession. shock to the global economy. The most likely candidates are:
As inflation is the bigger risk in emerging markets, – specifically China, a fiscal crisis in Europe that includes not one but several sovereign
India, and Brazil – pay attention to monetary conditions in all three defaults and an existential threat to the euro, a significant geopolitical
countries, particularly Chinese bank lending. Chinese loan growth event such as a major military conflict on the Korean peninsula
was still nearly 20% year-over-year in late 2010. That pace probably or in the Middle East, or a round of competitive devaluations leading
needs to moderate in 2011 to avoid an overheating Chinese economy. to a currency war.

The other crucial indicator of inflation will be commodity prices, Why this is not likely
particularly food. Unlike developed countries, food constitutes The global double dip is arguably the biggest threat to risky assets
a significant portion of a consumption basket in most emerging in 2011. While possible it still remains less likely than the grudging,
markets. For example, in China food prices constitute one-third grinding recovery we’ve been experiencing the last 6 to 12 months.
of the CPI basket. Any supply disruptions will complicate the inflation
Absent a policy error or exogenous shock the global recovery, while
picture in emerging markets, and raise the likelihood that emerging
fragile, appears self-sustaining. While it is true that significant risks
market central banks will need to tighten more aggressively.
remain – most notably unsustainable sovereign debt in most of the
developed world including the United States – the debt issue is unlikely

3
to erupt in 2011. Instead, a weak economy is likely to give the United CHART 3
States another year of breathing space. As long as private demand Chinese Purchasing Managers Index 2008 to Present
for credit remains anemic and the Fed is engaged in asset purchases,
we are unlikely to see a large-scale sell-off in the Treasury market. 70

New Orders Component

60
Factors to watch
50
One event which would make a double dip considerably more likely
40
would be any policy out of Washington that adversely impacts US
disposable income. Consumer debt is still levitating at unsustainably 30

high levels – roughly 120% of disposable income versus a long-term 20

average of around 80%. In addition, consumers are contending 10

with stubbornly high unemployment and lackluster wage growth. 0
Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10
The combination of high debt and a weak labor market would make
the consumer vulnerable under any conditions, but the situation Source: Bloomberg
is exacerbated by a growing dependence on largess from the federal
government (see Chart 2). Investment strategy

As the accompanying chart demonstrates, over the last few decades, If the risks of a double dip rise, investors may want to reduce their
government payments to individuals have constituted an ever larger exposure to equities, lower their beta, and – despite record low
share of income. The extension of unemployment benefits is obviously yields – reembrace US Treasuries and the dollar. Unlike the baseline
supportive, but investors should remain focused on other policy allocation, under this scenario investors may want to dramatically
issues, such as Social Security, that impact disposable income. raise their allocation to bonds, lower their allocation to stocks, and
In short, while contributing to the long-term fiscal imbalance, in the keep their remaining funds in cash.
near term equity markets are dependent on continuing government As inflation is likely to drop, investors may want to overweight sectors
generosity. A sudden embrace of fiscal austerity would, at least that have traditionally done well with little pricing power. Historically,
in the near term, endanger the recovery and equity markets. consumer staples and healthcare have done best in this environment.
CHART 2
More aggressive investors may also want to consider going long
less traditional assets, such as volatility. Equity market volatility is
Transfer Payments as a % of Disposable Income
currently pricing in an economic recovery and stable credit markets.
23 A recession, particularly if it was accompanied by widening credit
Transfer Pymts/Disposable Income (%)

21 spreads, would imply significantly higher volatility.

19

17

15
Scenario 3: Global Inflation
13
Probability 10%
11

9
What it would look like

7 The global economy accelerates, spare capacity is used up,

5 bank lending increases globally accelerating growth in the supply
Jan 59 Jan 66 Jan 73 Jan 80 Jan 87 Jan 94 Jan 01 Jan 08 of money, and prices start to rise. Inflation is particularly acute
Source: Bloomberg in those economies that are already running close to full capacity.
In the emerging world this means China, India, and Brazil and
Beyond US fiscal policy, watch Chinese manufacturing for any arguably Australia in the developed world.
signs that the credit tightening is slowing the economy beyond the As this is currently not priced into bond markets, we witness a dramatic
desired soft landing. Two useful statistics to watch are the Chinese bond market sell-off in both developed and emerging markets.
Purchasing Managers Index (PMI) and Chinese commodity imports As typically happens, the unanticipated spike in inflation also causes
– particularly copper and iron ore (see Chart 3). The latter provide a contraction in equity multiples and an ensuing sell-off in stocks.
a good real-time window into Chinese manufacturing activity. While Commodities, on the other hand, have a stellar year, lead by gold.
both the PMI and imports are likely to moderate in 2011 as the
Why this is likely or unlikely
government attempts to engineer a soft landing, sudden drops would
raise the risk that China’s economic deceleration will be more severe. There is a non-trivial risk of accelerating inflation in emerging
If the Chinese PMI fell below the 50 level, indicating economic markets and commodity prices. That said broad price inflation in
contraction, that would raise the risk of a global slowdown. most developed markets looks very unlikely over the next 12 months.

4
While unconventional monetary policy has raised the long-term risk of Factors to watch
inflation, there are several factors conspiring to prevent a meaningful The key factors to watch that would indicate an accelerating risk
acceleration in inflation in 2011. First, the global economy still suffers of inflation are bank lending and money supply growth, capacity
from too much capacity. In the United States, capacity utilization utilization and labor market growth.
is stuck at around 75%, versus a long-term average of above 80%.
Inflation has rarely accelerated until capacity utilization climbs above As discussed above, the inflation of the 1970’s was preceded by an
its long-term average, and even then it takes a year or so to get going. explosion in bank lending. Between 1972 and the end of 1973, US
commercial and industrial loan demand grew by approximately 15%
Not only is there too much spare capacity in the manufacturing year-over-year on average. As of October 2010, US loan growth was
sector, but obviously the same problem exists in the labor markets. down more than 8% year-over-year. Until loan growth recovers the
While slowly recovering, job creation in most developed countries near-term risk of a surge in the money supply, and a corresponding
is a long way away from the levels that have typically been associated rise in inflation, is limited (see Chart 5).
with wage inflation. In the United States, inflation has been rare until
the growth in jobs starts to exceed the growth in the population. CHART 5

Practically, this means inflation is less of a risk until non-farm payrolls US Commercial & Industrial Loan Demand
start to grow by 1.0% to 1.5% a year. Currently, non-farm payrolls 0.04
in the United States are up only 0.35% from a year ago.

C&ILo and Demand MoM

0.03
Some will argue – particularly those of a monetary bent – that inflation
0.02
is still a risk given the unprecedented amount of money creation we’ve
witnessed in the past few years. The Federal Reserve has tripled its 0.01

balance sheet over the past 2 years and plans to add another $600
0.00
billion in asset purchases during the first half of 2011. Given the
expansion in the monetary base, how can you not get inflation? -0.01

-0.02
CHART 4

Money Supply vs. Inflation -0.03

Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10

10 Quarters
9 Quarters Source: Bloomberg
Correlation QoQ Changes

8 Quarters
7 Quarters While loan growth is significantly stronger in emerging markets, recent
6 Quarters
policy changes appear to be effective in dampening growth. In China,
5 Quarters
4 Quarters
loan growth is down by nearly 50% from a year ago (see Chart 6).
3 Quarters
CHART 6
2 Quarters
1 Quarters China Total Loans Financial Institutions YOY
0 Lag
40
-0.05 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40
Quarterly Lag 35
Source: Bloomberg
YOY Change in %

30

The key is bank lending. While the Fed has aggressively created new 25

money, the vast majority of it is sitting on bank balance sheets in the

20
form of excess reserves. Unlike the 1970s’ bout of inflation, which
was preceded by a dramatic acceleration in loan growth, today, bank 15

lending is flat to negative. In the absence of loan growth, we’ve seen 10

only a grudging increase in the money supply (unlike the monetary Oct 03 Sep 04 Aug 05 Jul 06 Jun 07 May 08 Apr 09 Mar 10

base, the money supply includes checking account deposits but not
Source: Bloomberg
bank reserves). Until banks resume lending, the mechanism by which
the Fed’s monetary policy gets transmitted to the broader economy Investment strategy
is temporarily broken. This dramatically lowers the risk of inflation
next year, as even when the money supply eventually starts to In the unlikely event that the leading indicators of inflation – spare
accelerate; it typically takes two to three years to see the impact capacity, loan and money supply growth, labor market conditions –
in inflation (see Chart 4). start to flash yellow, investors may want to lower their allocation

5
to stocks (while stocks actually provide a decent inflation hedge be repeated, but some of them are likely to reverse in a way that will
over the long term, they generally suffer during the initial stages create an ongoing headwind for markets. First, both interest rates
of a pickup in inflation), bonds (TIPS and other inflation-linked and inflation are more likely to rise than fall over the long term. And
bonds being the exception), and raise their allocation to commodities. should that not prove the case, lower rates and lower inflation would
The asset allocation under an unexpected spike in inflation could imply Japanese-style deflation, not a particularly good environment
be more heavily weighted toward commodities, with the bond for any asset class other than bonds. At the same time, the peace
allocation dramatically reduced and the equity portion moderately dividend that was enjoyed has long since been eaten up in the form
reduced from the baseline. of two regional wars and an ongoing extension of the global security
apparatus. Finally, and most significantly, aging populations will put
Commodities have historically been the best performing asset class
increasing fiscal pressure on most developed economies. Rather
during the early stages of inflation, with gold in particular generally
than the rare budget surpluses that were present in the late 1990s,
providing an inflation hedge. Within investors’ stock portfolios, energy
most developed countries face daunting fiscal challenges that are
has historically been the most resilient sector under inflation (it has
secular rather than cyclical in nature – in other words the deficits
also performed well under a weak dollar regime) while investors may
do not go away even when the economy recovers.
want to underweight consumer discretionary and financial stocks,
the sectors that have historically had the highest negative correlation One other factor makes a return to the nirvana of the late 1990s unlikely.
with inflation. The 20-year bull market in equities and the 30-year bull market
in bonds were both preceded by secular bear markets in both asset
Finally, while many investors also consider REITs a good inflation
classes. As a result, both bonds and stocks started the early 1980s
hedge, the historical evidence is that REITs behave more like stocks
at historically cheap valuations. Equities, in particular, reached trough
than physical real estate. When inflation accelerates, REITs tend
valuations that had not been seen since the 1930s (see Chart 7).
to suffer the same multiple contraction as traditional equities.
CHART 7

Equity Valuations and Long Term Interest Rates

Scenario 4: Return to Goldilocks:
50 20
2000

Long-Term Interest Rates (%)

Price-Earnings Ratio (CAPE)

45 18
Low inflation, strong growth, buoyant equity markets 40
1981
16
Probability 10% 35 1929 14
30 1901 12
What it would look like 25
1966
10

The 1990s were distinguished by not only booming equity markets, 20 8

1921
15 6
but by a steady and reliable expansion in the global economy
10 4
combined with a period of low and stable inflation – the so called 5 2
‘Goldilocks’ environment. 0 0
1880 1900 1920 1940 1960 1980 2000 2020
A repeat of the 1990’s would entail a sudden acceleration in developed
Price Earning Ratio Long Term Interest Rates
market economies coinciding with a soft landing in the emerging
Source: Online Data Robert Shiller, http://www.econ.yale.edu/~shiller/data.htm
markets. Inflation stays low and while bond yields would be likely
to rise under this scenario, their rise is gradual. Given the low level
of bond yields, a modest sell-off in US Treasuries would probably In contrast, today, real bond yields are at the lower end of their
not disrupt equity markets. historical range and while equities are reasonably valued, they are
nowhere near the levels that typically precede secular bull markets.
Under this scenario equities perform particularly well. The more
industrial commodities would do well based on strong economic Factors to watch
growth, although gold would probably decline as investors grew As one of the major risks to markets over the long-term is sovereign
less concerned over inflation. debt, arguably one scenario that could precede the inception
Why this is not likely of a new secular bull market would be simultaneous and meaningful
fiscal reform in developed markets. If we were to see a combination
There were many one-off factors that were responsible for the
of short-term fiscal stimulus coupled with real, long-term tax and
unusually benign investment environment of the 1990s. Most of
entitlement reform, that could theoretically allow multiples to expand
these are impossible to repeat, including: the continuation of the
and long-term rates to remain low. With that in mind, investors
secular decline in interest rates and inflation that began in the 1980s,
will want to watch a few countries and events in particular to see
a one-time fiscal peace dividend at the end of the Cold War, and a
if governments are showing evidence of any real appetite for fiscal
temporary surge in productivity brought about by the incorporation
reform. First, pay attention to the debate around US debt ceiling
of new information technology. Not only can these conditions not

6
in March 2011. This could arguably provide a catalyst for a more Conclusion
serious discussion of the long-term deficit. Second, in the United
Kingdom does the coalition government stick to its planned spending “Give me chastity and continence, but not yet” - Augustine of Hippo
cuts? Finally, watch Spain. Spain is important as it is the largest, After the drama of the last four years, our baseline scenario for 2011
by far, of the sovereign debt risks in Europe. Loosening restrictions is for a temporary lull, and probably a good year for equities. Bonds
in the Spanish labor market coupled with further consolidation of the are likely to hold up, at least through the first half of the year, but given
smaller Spanish banks (cajas) would represent important structural valuations and supply issues they don’t appear to offer the best value.
reform and help lower the risk of an eventual EU debt crisis.
That said, it is important to note that our relatively sanguine
We are skeptical, particularly in the United States, that we will outlook for next year does not imply that the global economy has
see any real fiscal reform in 2011. Countries rarely enact painful put its troubles behind it. On the contrary, many of the structural
fiscal restructurings without a catalyst and an election. In the past, imbalances that pushed us into the global crisis are still with us,
fiscal reform – for example, Canada and Sweden – only occurred albeit in an altered form. Ironically, many of the policies that are likely
following an election and change in government. While the United to promote a decent year for economies and markets, i.e. extension
Kingdom obviously satisfied that criteria, it suggests that real of the Bush tax cuts and maintaining transfer payments to individuals,
reform in the United States is unlikely until after the 2012 election. will exacerbate the longer-term imbalances. At some point, the strain
Investment strategy is likely to begin to show even on the largest and richest nations, the
United States, but that is probably not an issue for 2011.
In the unlikely event that the United States, European Union, and
Japan summon up the political coverage for meaningful fiscal reform,
investors could consider going long risky assets, specifically equities
and high yield. Again, commodities are likely to perform respectably,
but the absence of any inflationary pressure implies that equities,
not commodities, will be the best performing asset class. Under
the Goldilocks scenario, equities could have a significant overweight,
bonds a modest allocation, and the remaining part of the portfolio
in cyclical (i.e., not precious metals) commodities.

7
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