Financial markets enter with three risks in 2011

LONDON (Reuters) - Financial markets enter 2011 with many investors persuaded that the world economy is on the mend and that riskier assets such as stocks are set to do well.

Data from Reuters asset allocation polls and State Street’s investor confidence index suggest investors are positioned for more stock gains and a continued move away from supposedly safer assets such as government bonds and low-yielding cash.

The Reuters polls, for example, showed equity holdings among leading investors at a 10-month high in December, while State Street’s index for the month moved into bullish territory for the first time since March.

But the waning days of 2010 suggest investors will almost immediately have to face three major risks to their rather bullish mood.

In no particular order, those are: China’s trade, America’s economy and the fate of billions of dollars pumped into benchmark government bonds.

Of the three, the pace of recovery in the U.S. economy will be most clearly on display, with monthly U.S. jobs data due to be released on Jan. 7.

It may take on extra importance this month as much of the change in investors’ appetite for risk has come about as signs have increased that the U.S. slowdown in mid-2010 was only temporary.

U.S. equities, for example, have recovered to the extent that the over-the-counter Nasdaq index has actually outperformed much-touted emerging market stocks, as measured by MSCI.

But some data was disappointing in the past week, notably consumer sentiment and housing, which, with jobs, go to the heart of future confidence and spending.

U.S. equities have been among the big winners since Federal Reserve Chairman Ben Bernanke made clear in August that the Fed would buy more assets to boost liquidity in the U.S. economy.

The S&P 500 index, for example, is up around 20 percent since his Jackson Hole Aug. 27 speech.

So any sign that the U.S. economy is not recovering as thought could cause an early reversal.

A not-unrelated worry is the Treasury market, which has been hit by a combination of rising prices for riskier assets, the impact of tax cuts on the already large U.S. deficit, and a general feeling that bonds may be overbought.

The past few weeks have seen a few days of large sell-offs, including one following dismal demand at an auction for five-year paper.

“Short- to medium-term maturities generally offer poor value,” Tristan Hanson, strategist at wealth manager Ashburton told clients recently.

He added, however, that longer-term 30-year paper was a good backstop against any renewal of concern about global growth.

An orderly sell-off of bonds would not unduly worry investors and would fit with their scenario of rising “risk” assets.

Were Treasuries and other benchmark bonds such as Bunds to sell off too sharply, however, significantly higher yields would unsettle investors and have the reverse impact on liquidity than that sought after by the Fed and various other authorities.

Reuters latest polls on expected bond yields found a median projection of 3.40 percent for U.S. Treasuries around a year from now. The yield has already revisited those levels this week.

The third risk that investors may face in the coming week is China’s decision to cut its export quotas for rare earth minerals by 35 percent for the first half of 2011 versus a year ago.

Rare earth minerals are used in a range of products from MP3 players and computer hard drives to hybrid cars, wind turbines, light bulbs and coffee makers.

They are also not as scarce as their name implies, but China has cornered about 97 percent of the market by producing them far cheaper than anyone else can.

The issue for investors is not so much whether the prices rise -- although it won’t ease the concerns of those who fear a return to inflation in the developed world.

What may concern them most is the potential for China’s action to trigger trade disputes. The United States and European Union have already either expressed concerns or reminded China of its supply obligations.

It may prove a fleeting concern, but investors have listed for some time the danger of trade wars as one of the biggest threats to the recovering global economy.