The top 10 surprises of 2009
BY DIRK HOFSCHIRE, CFA, VICE PRESIDENT OF MARKET ANALYSIS, FIDELITY VIEWPOINTS — 01/05/10
Editors’ note: The editors of Fidelity Interactive Content Services (FICS) chose this piece for its insight into what spurred the market’s recovery in 2009 and what might take place in the year ahead.
In a year of mostly pleasant surprises, investors found relief following a disastrous 2008. The following is the MARE group’s list (in no particular order of priority) of the most surprising developments in the financial markets in 2009.1
1. Abrupt turnaround, tremendous rebound
We entered 2009 smack in the middle of a global financial crisis, plunging asset values and concern that a 1930s-style economic meltdown was possible. By early spring, signs of stabilization emerged in the credit markets and the global economy, and asset prices put in a bottom. By the end of 2009, markets had posted one of their biggest and most broad-based rallies in years. The sudden reversal was most stunning in the complete about-face of investor risk appetite—from complete flight from risk to wholehearted embrace of it. Stock markets everywhere rallied dramatically. The U.S. stock market (S&P 500 Index ended its worst bear market since the 1930s in March, then put in its best nine-month start to a bull market on record (up more than 20% for the year overall). Technology stocks led the way, up more than 50% and propelling the growth-stock category to its best year since the 1990s. In fixed income markets, riskier high-yield corporate bonds had their best year ever. Financial market roller coaster rides have rarely, if ever, featured these types of highs and lows within one calendar year.2
2. Federal Reserve’s extraordinary actions
In an effort to combat the global financial crisis and economic downturn, central banks around the world slashed interest rates to record-low levels. However, the U.S. Federal Reserve (Fed) stood above all policymakers in its willingness to employ unprecedented measures. In addition to lowering its policy rate to near zero percent, the Fed implemented a quantitative easing policy that included purchasing $1.45 trillion of government bonds. As a result, the Fed is on pace to own one-fifth of the entire (government-guaranteed) mortgage-backed security (MBS) market by early 2010. The massive injections of liquidity undoubtedly helped boost global asset prices in 2009, and they probably deserve some credit for averting a bigger economic and financial crisis. However, the questions about when and how effectively this extraordinary liquidity will be unwound remains a key question for 2010.
3. Bond market rally
Risk-taking was rewarded mightily during the 2009 market rally, but the typically stodgy fixed-income category generated surprisingly strong returns as well. Yes, the performance of the riskiest slices of fixed income, such as high yield-bonds (up more than 50%) and leveraged loans (up more than 25%), provided the most spectacular gains. But after suffering severe beatings in 2008, even higher-quality bonds issued by investment-grade corporations and municipalities provided double-digit total returns to investors in 2009. Government-guaranteed bonds also showed surprising resilience in an environment of improving economic data that could have dramatically reversed last year’s flight to safety. Treasuries suffered minor losses, but mortgage-backed securities with government credit guarantees posted solid gains amid Fed purchases. Though mutual fund investors largely ignored the 2009 stock rally, they flocked to fixed-income funds in record numbers.3
4. Profit recovery—without the sales
The fourth quarter of 2008 went down as the worst on record for U.S. profits, with operating earnings at S&P 500 companies dropping by more than half. Nine months later, through the third quarter of 2009, corporate earnings had more than doubled off their 2008 lows. Driving the profit recovery was not the improving economy—in fact, sales in the third quarter were still lower than they were at the end of last year. The primary factor was rapid, massive corporate cost cutting, where firms effectively slashed payrolls and other costs at a faster rate than their sales environment deteriorated. The result was a mixed bag. Unemployment leapt to above 10% (the number of employed workers is back to pre-2000 levels), and weak labor markets and income growth remain a big drag on the economic outlook. However, with labor productivity rising at its fastest rate in years and businesses perhaps leaner than ever before, corporate profitability stands to rebound further if economic activity strengthens in 2010.
5. Financials—back from the brink
The financial crisis still raged at the beginning of 2009, with several well-known Wall Street institutions gone from the industry landscape while others clung to government lifelines. However, a “stress test” by regulators gave investors renewed confidence, and by spring big banks were able to tap public markets to raise capital and fortify their balance sheets. Bond issuance recovered, bank profits rebounded and the credit markets staged a dramatic recovery. By the end of 2009, many large firms had paid off emergency TARP money and some even moved to pay record bonuses. Financial stocks declined 50% from the beginning of the year through March 9, then more than doubled during the remainder of the year.4 The financial system is not yet out of the woods—smaller banks are struggling, consumer and real estate loans are still going into default, and the number of bank failures continued to climb. But compared to the near-financial system collapse the prior year, 2009 was the year of a rapid redirect away from the abyss.
6. Emerging markets led the world
Emerging-market stocks went from the worst performing asset category in 2008 to the best in 2009, with returns topping 70% for the year. Perhaps that is less surprising when considering the stocks of developing nations have historically been the most volatile, typically being routed during bear markets while soaring during bulls. The biggest revelation in 2009 was that emerging economies actually led the world out of recession. By the second half of 2009, China and India had both re-accelerated their economic growth to near pre-crisis levels of between 7%-10%.5 Brazil and other raw materials exporters benefited from recovering commodity prices. Many emerging markets boosted domestic consumer spending while the U.S. consumer retrenched. The speed with which the developing world got back on its feet after a global recession was unprecedented, and its quick re-emergence keyed the worldwide recovery.
7. Fiscal deterioration, rise of sovereign risk
As the global recession hit hard in early 2009, government tax revenues plunged around the world, at the exact same moment most countries spent generously on stimulus programs to combat economic weakness and financial instability. The result was a massive re-leveraging of the public sector, with soaring budget deficits from Spain to the United States. As 2009 wound to a close, small country fiscal issues grabbed headlines, as Dubai’s ability to meet its debt obligations was questioned and Greece’s credit rating was downgraded. While there are plenty of other smaller nations facing near-term pressures, the bigger story for next year will likely be around large, fiscally-challenged developed countries such as the United States, U.K. and Japan. Many of these big mature economies face some combination of near-term revenue growth challenges and longer-term demographic headwinds, which likely leaves investors looking for signs of fiscally sustainable policies to emerge in 2010. The results could have significant impact on interest rates, tax rates and growth prospects for several of the world’s largest economies.
8. Gold break-out
After holding up relatively well as a perceived safe haven during the late-2008 financial crisis, gold prices roared to new record nominal highs in late 2009. Passing $1200 per ounce for the first time ever, gold received a boost from a falling dollar amid investor concerns about loose U.S. monetary policy and big government budget deficits. However, gold also rallied against other major currencies, suggesting investors may generally be using it as a real asset hedge against potential weakness in paper currencies and the prospects for inflation down the road. Whatever the reasons, gold was one of the best assets to own this decade, up roughly 300% from the beginning of 2000.6
9. Housing stabilized
The residential U.S. housing market—whose downturn was arguably the epicenter of the global financial and economic crisis—finally found some stability in 2009, after three years of unprecedented, post-bubble declines. The sales and prices of existing homes stopped falling by mid-year, giving much-needed relief to the construction sector, homeowner balance sheets and financial firms holding mortgage-related securities. It is true that government support for housing was a major factor in the improvement, including driving down mortgage rates (through the Fed’s MBS purchases) and providing tax breaks to first-time homebuyers. Also true is that foreclosure rates are still sky high and many housing-bust regions remain severely troubled (i.e. California, Florida, Nevada). But after the free-fall that shaved one-third off home values since the peak in 2006, just finding some stability was a major development for the U.S. economy and financial system.
10. Inflation vs. deflation: Unresolved
In 2009, monetary authorities flooded the system with liquidity, government debt levels spiked, commodity prices recovered and gold hit new highs. Clearly, said many experts, the threat of inflation looms. On the other hand, 2009 saw a contraction in bank lending, U.S. consumers saved more and borrowed less, unemployment rose above 10%, and the consumer price index turned negative for the first time in 50 years. Clearly, said other experts, the threat of deflation has not disappeared. The biggest surprise might be that this debate survived largely intact into 2010, with both potentially inflationary policy measures and potentially deflationary financial and consumer de-leveraging still in place. The fact that such dramatically different scenarios remain plausible underscores how much macroeconomic uncertainty remains, even as the recovery gained traction moving into 2010.