Hot Plus Cold Not Doesn’t Equal Just Right

Capital markets have lately been incorporating that hot Asia plus cold industrial countries concurrently do not become equal to just right, without a workout that blends two solitudes. A required unfolding of workout is likely to apply to policy delivery and market behavior. On currency, we are encouraged by the euro decline, see need for a lower Yen, recognize incremental steps from China now including yuan products in Hong Kong but see need for integrative action within ASEAN also. At this point of earnings recovery, we maintain unusual value develops below 1050 (S&P 500 at 1071; MSCI World at 1089) but exceeding the 2010 highs (over 1250) is likely prolonged to mid 2011. Back in 2006, lack of differentiation in capital markets over risk quality became important for us. The subsequent process is already close to four years old but incomplete.

From unemployment to credit failure to earnings decline and corporate failure much has taken place in workout for industrial countries but sovereign debt vigilante behavior is elevating. In emerging countries, containing the political pressures from rising inflation have also become higher priority issues. By early Q2/2010 with complacency on government largesse, market behavior had moved well ahead of earnings and policy delivery. The sovereign debt and the first tranche of earnings releases after Q2/2010 underscore that workout remains underway. The full flowering of a quality overlay on portfolios is still to bloom. Serial exaggeration, part of capital market lexicon for fifteen years, needs next to diminish for progress. It currently oscillates between expectations for seamless recoveries versus double dip into recession. Better blending is likely to require moderating fast growth with more integration in Asia and boosting growth in industrial countries. For earnings now being released from Korea to Europe and the bulk now in the United States, we see bifurcation within industries likely as important as amongst them, during lower recovery than consensus. For industry at large and in the crucial financials, recurring revenue growth capabilities are likely now to be a crux, in contrast to serial exaggeration and consensus tendencies experienced in the last cycle. Quality differentiation related to operations and balance sheets is likely to be a key theme even within our favored sectors of energy, healthcare and information technology.

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