SOARING STOCK markets and a plummeting dollar hogged the headlines in 2009 but analysts expect 2010 to be dominated by bond market developments as the precarious nature of government finances across the globe increasingly come under the microscope, writes PROINSIAS O'MAHONY

On average, fund managers expect equity returns of 7.7 per cent, according to Michael Hartnett, Merrill Lynch’s chief global equity market strategist.

Merrill’s most recent survey of global fund managers reveals that two-thirds expect equity returns to return to traditional growth levels or better while expectations for corporate profits are at their highest level since December 2003.

Less optimistic strategists, such as illustrious fund manager Jeremy Grantham or Société Générale’s famously bearish Albert Edwards, point to stretched long-term valuation metrics as evidence that 2010 will prove a trying year for investors.

Edwards’s colleague Andrew Lapthorne warns that 2010 consensus earnings forecasts project profit growth of 27 per cent – the highest level on record. Even if that growth is somehow attained, cyclical sectors are nearly 30 per cent more expensive than defensive stocks.

“With several cyclical indicators on the wane, and dollar strength eroding the carry trade, we would expect many investors to conclude that the safer stance is now with the defensives,” Lapthorne concludes.

The aforementioned carry trade, whereby investors borrow dollars at near zero interest rates and invest in higher-yielding assets across the globe, was a contributing factor in the greenback’s 17 per cent slide against a basket of major currencies between March and November – the biggest eight-month slide since 1986.

The preponderance of dollar bears prompted celebrated contrarian investor Jim Rogers to recently predict a “nice rally” for the US currency, despite his deep misgiving about its long-term future.

December has seen strong gains for the dollar and while some see this strength as short-lived – Goldman Sachs predicts that the euro, currently worth $1.44, will hit $1.55 within three months – a growing army of dollar bulls has become evident of late.

New York economist Nouriel Roubini maintains that the carry trade will unwind in 2010, with bouts of global risk aversion causing investors to flock to the safe haven of the dollar. Merrill Lynch, whose optimistic attitude to 2010 is in stark contrast to Roubini’s, agree that the dollar will “get some respect” in 2010, arguing that it’s “over 10 per cent undervalued” against the euro and that the US economy should grow in 2010 while keeping inflation in check.

Verbal “interventions” from Federal Reserve chairman Ben Bernanke, who recently said he was “attentive to the implications” of dollar weakness, should prevent the euro from any “meaningful” advances, Merrill said. The firm projects that the euro will fall below $1.30 next year.

Strategists are increasingly wary of the euro, which has slid recently amid growing talk of sovereign debt issues in Greece, Spain and Ireland, as well as obvious banking weakness in several euro-zone countries.

Widely varying national economies and the lack of “fiscal federalism”, a recent analyst report by Standard Bank said, pointed to “real problems” for the euro in 2010 while RBS’s Greg Gibbs said that the ECB would, “when push comes to shove”, feel compelled to support Greece, thereby weakening the outlook for the euro.

Nor is there any great enthusiasm for sterling, with analysts focusing on fears that credit rating agencies might actually downgrade the country’s debt as well as uncertainty regarding the coming general election and a possible hung parliament. The fragile UK economy means economists don’t expect rock-bottom interest rates to rise until the third quarter of 2010.

However, sterling’s fall from €1.53 to just €1.10 today, coupled with the euro zone’s new-found reputation as the “problem child as regards public finances”, as Commerzbank analysts put it, means that many strategists view further losses as unlikely.

Commerzbank’s quip is echoed in many analyst reports, with many expecting equity returns to be dictated by bond market movements – “sovereign land mines disturbing the benign corporate landscape”, to quote Deutsche Bank’s Jim Reid.

There is “an increasing risk of a sovereign crisis occurring in the developed world”, Reid said, noting that financial crises have historically been followed by sovereign defaults. Markets needed evidence of a path back to fiscal discipline. If “certain western countries” could not provide this evidence, a large rise in government yields was possible, raising funding costs “to levels that encourage a vicious cycle”.

Most likely, a crisis would be avoided but of four potential 2010 scenarios outlined by Reid, the possibility of sharply higher bond yields disrupting equity market momentum was deemed the second most likely.

Reid’s sentiments were echoed by Pierre Cailleteau of rating agency Moody’s. “The overriding theme is that 2010 will at best see a ‘normalisation’ and at worst a severe tightening in government financing conditions,” he said.

Top-rated AAA countries like the US and the UK had lost their shock-absorption capacity and could soon pay a higher price for their mounting debt. Accordingly, they “will probably not have the luxury of waiting for the recovery to be secured before announcing credible fiscal consolidation plans”.

Bond markets were right to be concerned about Greece, said Merrill Lynch, and “perhaps Ireland” too. Irish analysts are largely optimistic that the currently high yields on Irish debt will come down in time, given the Government’s fiscal retrenchment, a position shared by Goldman Sachs. It lists a reduction in Irish spreads as part of one of its top 10 trades for 2010.

Despite that, however, Merrill warns that “spread widening can temporarily go much further than economic fundamentals warrant”. Moody’s, while praising Irish people’s “high pain threshold” after cuts that were “unimaginable” not so long ago, is concerned that this “fortitude” might diminish amid potentially increased social tension in 2010.

If 2010 is a difficult year, analysts seem to think it unlikely that the catalyst will come from the equity markets. “Sovereign debt around the world will probably decide the fate of risk assets,” Jim Reid concludes.