MEET THE SUPPORTING CAST / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

JANUARY 3, 2011.

Meet the Supporting Cast

Markets Continued to Benefit From Intervention in 2010; Now, the Question Is, Can the Fed and Others Exit Neatly?
 
By TOM LAURICELLA

Anita Kunz



Financial markets of just about every stripe pushed higher in 2010, marking a second year of recovery from the financial crisis.

As was the case in 2009, investors can thank continued, unprecedented efforts by governments and central banks around the globe to keep their economies and financial markets afloat for those good returns.

At some point, governments will look to reverse their stimulative strategies as their economies and markets can stand on their own. But for now the betting is that in the U.S., Europe and Japan, at least, that support will continue for months to come.

The benefits to investors could be seen in 2010. When major stock or bond markets faltered and ostensibly signaled alarm, policy makers responded aggressively with measures that, at least in the short term, directly or indirectly drove prices higher across a wide variety of asset classes.

The most direct support came as central banks supported government bond markets in the U.S. and Europe. That then indirectly lifted corporate bond and stock markets..

U.S. stocks also got a boost in December thanks to an unexpected round of fiscal stimulus for 2011 in the form of extended and new tax breaks. The Dow Jones Industrial Average gained 11% to 11577.51, regaining levels last seen before the collapse of Lehman Brothers in September 2008. The Standard & Poor's 500-stock index, meanwhile, rose 12.8% to finish at 1257.64.

The Dow, which finished less than eight points shy of its high for 2010, capped the year with a 7.3% gain in the fourth quarter and an 18.5% rise in the second half. With those gains, the Dow stood 76.8% above its 12-year low close of 6547.05 hit on March 9, 2009, but is still 18% below its all-time high of 14164.53 reached Oct. 9, 2007.

Prices of economically sensitive commodities climbed as central banks in many emerging markets held off raising interest rates despite strong growth and building inflation pressures for fear of damaging the fragile global recovery.

Copper prices, for example, rose 33% and crude-oil prices gained 15% to finish the year above $91 per barrel. The bet was that as long as China and other raw-material-hungry countries keep growing at a fast pace, their demand would provide a bid for commodity prices.

In another indirect effect of global stimulus efforts, investors worried about long-term damaging effects, especially the possibility of higher inflation and exploding budget deficits, and bid up gold prices to record highs. Gold prices rose $325.90 per troy ounce last year, or 29.8%, to $1421.10.

"The markets and economies aren't being left to their own devices," says Jason DeSena Trennert, chief investment strategist at Strategas Research Partners. "Policy makers are trying to move heaven and earth."

This isn't quite the way many investors had expected 2010 to play out. As the year got under way, many investors were pondering how well the markets would stand on their own as the rescue efforts launched in late 2008 were pared back.

Now, as 2011 begins, the talk of "exit strategies" is concentrated only on the emerging markets, where some central banks, such as those in China and South Korea, are starting to ramp up tightening efforts.

Among the world's biggest developed economies—the U.S., Japan and much of Europe—the consensus is that support efforts will continue. That should be good news for riskier investments, such as stocks, high-yield bonds and commodities.

For now, "very few investors are talking about unwinding" stimulus, says Erin Browne, macro strategist at Citigroup.

"Everyone sees it as an eventuality but it's not something that is on the near-term horizon."

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The story of 2010 shows how government support continued to prop up financial markets. By the end of the first quarter, U.S. stocks were on an upswing as solid earnings and improving economic news helped the Dow in April top the 11000 mark for the first time since September 2008.
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Then, in early May, the European debt crisis began to boil over from Greece.

Contagion threatened other euro-zone countries and European banks.

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With turmoil spreading in the European bond markets, European governments unveiled a nearly trillion-dollar rescue fund on May 9 aimed at stabilizing financial markets. The staunchly independent European Central Bank, meanwhile, bought some €40 billion of government bonds in the open market during May.

Those efforts gave stocks and other markets a brief boost. By July, however, the Dow was down 7% and back below 10000 amid fears that the U.S. economy was sliding back into recession led by renewed weakness in housing and a faltering jobs market. But the Federal Reserve rode to the rescue.

The turning point for the year came in late August, when during a speech in Jackson Hole, Wyo., Fed Chairman Ben Bernanke opened the door for a second round of so-called quantitative easing. Stocks again began to march higher.

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In September, the Fed made it official: The central bank planned to pump $600 billion into the financial markets through purchases of U.S. Treasurys.

By its very nature, quantitative easing is designed to inflate prices of financial assets. Through massive purchases of Treasurys, the Fed is keeping bond yields low and displacing other investors. This forces them to buy riskier investments, such as stocks or corporate debt, an effect that eventually filters through to the economy.

The rally was given a final boost for the year in mid-December thanks to another round of government stimulus. While investors had been closely watching negotiations between the White House and Republicans over an extension of Bush-era tax cuts, they were surprised by news of a 2% reduction in Social Security payroll taxes for 2011 in addition to two more years of the Bush cuts.

"Eventually, of course, there will be a cost to all these efforts," Strategas's Mr. Trennert says. But for the time being, investors are being rewarded for not fighting the tide. "Our phrase at the beginning of 2010 was 'bullish until the bill comes due' and that's still our view. It's hard to stand in front of all that stimulus."

The stimulus efforts, by raising economists' short-term expectations for U.S. growth even in the face of a very weak housing market and stubborn long-term unemployment, has investors putting money back to the U.S. stock market, says Arnab Das, managing director of market research and strategy at Roubini Global Economics.

For most of 2010, global investors had been pulling money out of U.S. stocks. In the first 11 months of the year, U.S. stock funds had suffered withdrawals totaling $22 billion. Meanwhile, investors poured a record $80 billion into emerging-market stock funds and $34 billion into emerging-market bond funds, according to EPFR, which tracks global bond funds. (U.S. investors, meanwhile, were abandoning U.S. stocks in favor of bond funds and foreign funds of all kinds.)

But in December, the tide turned sharply for U.S. stocks. In just three weeks, investors pumped more than $22 billion into U.S. stock funds, EPFR says. "We think that process of portfolio reallocation has a bit further to run  and we're looking for a tactical outperformance of equities" in 2011, Mr. Das says.

Still, Mr. Das says investors shouldn't ignore the reason for the support efforts. Fiscal and economic structural problems are "at the heart of why we need so many Band-Aids," he says.

That means risks remain, especially in Europe during the first half of the year, Mr. Das and others say.

"Event risk in the euro zone remains very high," Mr. Das says. "Portugal's turn will come and there's better than even odds that Spain, too, will be significantly tested in the coming couple of quarters."

There is a different dynamic in the emerging markets. Market support has come not from active intervention but rather from caution in withdrawing stimulus even as those economies have recovered better than those in Japan, Europe and the U.S. But that sentiment seems to be changing.

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Facing growing inflation issues, "policy makers are looking to withdraw stimulus at a more rapid pace," says Ramin Toloui, co-head of emerging markets at Pacific Investment Management Co. "The key thing for emerging-market countries is going to be a measured withdrawal."

The question facing investors is how emerging-market governments and central bankers handle the task of taking their foot off the gas at the same time as the accelerator is still being pushed in the U.S. Making the task trickier could be higher commodity prices, which by fueling inflation, could force emerging markets to tighten more aggressively. That, in turn, could spook other markets.

Citigroup's Ms. Browne thinks the tightening efforts in emerging markets will weigh on stocks in those parts of the world. "The U.S. market will still be bolstered by the easy liquidity provided by the Fed," she says.

The split between policies in the G-3 economies—the U.S., Japan and Europe—and emerging markets is on the mind of many investors. Pimco's Mr. Toloui says: "Managing this multispeed world is going to be a key theme for 2011."

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