Markets extend rally in 2010

2010 turned out to be another good year for markets.

While stock markets around the world did not put in the spectacular gains seen in 2009, gains in 2010 were still mostly quite respectable, with the Morgan Stanley Capital International World Index rising 9.6 percent in 2010.

Still, stocks were outperformed by commodities in 2010. The Thomson Reuters/Jefferies CRB Index of 19 commodities rose 17.4 percent last year.

A sustained recovery in the global economy as well as the announcement of additional monetary easing in November by the Federal Reserve through the purchase of longer-term Treasury securities -- more popularly called quantitative easing 2 -- were the catalysts for the positive performances of markets in 2010.

Markets were held back though by Europe's sovereign debt crisis. The euro fell 6.5 percent against the US dollar in 2010, negating most of the STOXX Europe 600 Index's gain of 8.6 percent for the year.

In 2011, markets are likely to be dominated by the same forces as last year.

The rate of economic growth will obviously be an important factor for markets. The global economy is generally expected to continue growing, albeit at a slower rate. In its October World Economic Outlook, the International Monetary Fund projected that the global economy will grow by 4.2 percent in 2011, with a slowdown in the second half of 2010 continuing into the first half of 2011. For developed economies, the Organisation for Economic Co-operation and Development sees growth slowing to 2.3 percent in 2011 from 2.8 percent in 2010 but rebounding to the latter rate in 2012.

While continued global growth is likely to support markets, the European sovereign debt crisis may continue to weigh on markets. Apart from the drag on the economy resulting from the fiscal austerity being adopted in the debtor nations in efforts to service their debts, many economists consider at least some of the crisis countries to be insolvent anyway, so some form of default is likely eventually. Whatever the form, bond markets and, ultimately, markets in general are unlikely to emerge totally unscathed, although political action -- or inaction as the case may be -- may keep the path of crisis resolution uncertain over the course of 2011.

While monetary policy on the whole -- but particularly that of the Federal Reserve -- was supportive of markets in 2010, things could change in 2011. Just last Thursday, Taiwan's central bank raised interest rates for the third time this year while its larger cross-strait neighbour China raised interest rates on Christmas Day and is expected to raise rates further in 2011 to fight off inflation.

However, stock markets are unlikely to be seriously threatened by tighter monetary policy for the first half of the year. The Federal Reserve's monetary policy stance is still the most important for global markets, and for the first half of the year, it is likely to remain accommodative as it is expected to continue to buy Treasuries until June.

This could change in the second half of the year though. The Fed's Treasury purchases are unlikely to be extended beyond June as the United States economy is expected to re-accelerate over the year. The cessation of Fed buying of Treasuries would obviously affect bond prices but probably those for other assets as well. In addition, by the second half of the year, investors may start focusing on the possibility of an interest rate hike by the Fed.

So while the global economy is likely to continue growing in 2011, investors would do well to continue monitoring developments on Europe's sovereign debts and the exit of central banks from ultra-loose monetary policies.