2011 Analysis: "The market is running on twin turbos"

By: Jurrien Timmer, Fidelity Investments, Director of Global Macro

I'm bullish because I see a scenario unfolding over the next six months that echoes that of 2009. Recall that in March 2009, the markets were pricing in Armageddon, a severe depression. Instead, the Federal Reserve intervened on the order of $1.75 trillion in 2009, through its first quantitative easing (QE), and the recovery began. The S&P 500 shot up 80% from its March 2009 low.

Fast forward to 2010. In the spring of this year, fiscal stimulus was on the wane. The rebuilding of inventories, which had helped GDP, had run its course. So these drivers of recovery were ebbing just as the European debt crisis was threatening to spread contagion to the U.S. financial system. We had a mid-cycle slowdown, and the market started to fear a double-dip recession. It was a little like early 2009 though on a more modest scale.

But, as in 2009, the Fed stepped in with QE2 and injected $600 billion into the financial system. Once the Fed signaled this was going to happen, the stock market took off and had its best September since 1939.

A repeat of 2009

I'm looking for this process to continue in the first half of 2011. We're getting an organic economic recovery plus aggressive Fed monetary stimulus. So it's like the market is running on twin turbos.

I'm what I call "risk on" — bullish on traditionally riskier investments like stocks, corporate debt, commodities, gold and silver, non-U.S. dollar currencies and emerging market stocks. I am negative on the dollar and U.S. Treasury bonds.

Exodus from bonds?

Another reason I am bullish for 2011 is that investors might start to think about exiting bond funds. From October 2007 to October 2009 bond funds attracted $650 billion, which is a staggering amount. At the same time, $265 billion has been redeemed from stock funds since the October 2007 high, according to the Investment Company Institute.

With interest rates low, the bond market isn't providing much in terms of returns. Stocks, meanwhile, are up 20% from their July lows and up 10% year to date. If $200 billion to $300 billion leaves the bond market and goes running after stocks, it could send interest rates higher and push up stocks. I don't know if that will happen, but we should not underestimate the impact if it does.

Down on Treasuries, up on corporates, high yield

I divide the bond market into two separate camps. I'm bearish on Treasuries, because the risk is that interest rates will move higher. Still, I am more positive on corporate and high-yield bonds, because an economic recovery should help the corporate side.

Bullish on gold, silver, foreign stocks and currencies

At the same time, I believe the dollar will continue to weaken because of the loose monetary policy being pursued by the Fed, and also by Europe, the UK, and Japan. Many other countries—China, Australia, and Brazil—are actually starting to tighten rates because growth and inflation have picked up.

Since gold and silver are priced in dollars, they will rise as the dollar falls. I would expect non-U.S. securities and non-U.S. currencies may also appreciate, reflecting the dollar's decline. This is why I'm also bullish on those investments.

QE3?

With fiscal stimulus waning, the Fed has to do nearly all the heavy lifting to keep a still fragile organic recovery alive. This reliance on monetary stimulus is actually more pronounced in Europe, where fiscal austerity is causing the European Central Bank to apply all the stimulus. Governments can't do it, because they are cutting spending

This may even play out in the U.S. municipal market, because local governments are facing budget pressures and cutting spending. If I were the Fed, the muni market would seem like an obvious choice to do QE3. But this is entirely my conjecture—the Fed has not said anything about it.

The thing to remember is that so much is at stake for the Fed. It has thrown all its political capital into the fight against recession. So I don’t think the Fed is going to just sit there now and let it all its work be destroyed. I think the Fed is going to do whatever it takes to keep the recovery alive, even if it means very unconventional measures.