In 2010, the monetary policies of the world’s three largest central banks are likely to play a big role in the performance of global equity markets. The vast majority of the world’s wealth—close to 80%, by some estimates—is concentrated in the U.S., Japan, and the euro area. My chart shows that the GDP-weighted risk-free rate in these three economies is only 0.14%. A 0.14% T-bill rate would not be a concern if the global economy were still in free fall, but it isn’t. The global economy bottomed in the second quarter of 2009. The IMF projects that the global economy will grow by 4% in 2010. When a risk-free interest rate of 0.14% is being offered to investors who own 80% of the world’s wealth, and real economic growth is 4%, you can be assured that capital will flow from low-yielding, risk-free T-bills into risky assets that offer higher prospective returns. How and when the Fed, the European Central Bank, and the Bank of Japan remove policy accommodation will likely determine which markets perform best in 2010. If monetary policy is kept easy for too much longer, you are likely to see asset bubbles develop in the world’s fastest-growing economies. If monetary policy is tightened sooner rather than later, as it should be, look for a flight to quality trade.
Investing in an environment where returns are so dependent on monetary policy is most unwelcome. To invest successfully in such an environment, you want to invest for income or where an embedded secular trend is supportive of growth. Special situations, including distressed securities, which don’t always move in lock-step with broader equity markets, are another area to favor.
Jeremy Jones, CFA
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