Prospects for 2010: Good, but could do better

2009 was a year like no other in terms of the changing fortunes of the global economy and capital markets. Fears of a second Great Depression were superseded by tangible signs of global recovery, equities rebounded sharply from multi-year lows and, having collapsed early last year, risk appetite ballooned. On the face of it then, the prospects are bright for 2010, but – with the recovery yet to become self-sustaining – problems still lurk in the shadows.

The global economy is getting back on its feet and should continue to recover in 2010, thanks to the liberal administration of policy stimulus, both monetary (low interest rates and quantitative easing) and fiscal (tax cuts and spending packages). Central banks worldwide have been at pains in recent months to underline their commitment to maintaining ultra-accommodative measures until the recovery is embedded. And, although public deficits have ballooned to the worst levels seen in peacetime, governments too are continuing to play their part in shoring up the economy through the likes of car scrappage schemes and mortgage subsidies in the US.

"The global economy is getting back on its feet and should continue to recover in 2010."

The impetus for growth this year also stems from other quarters, through firms’ rebuilding of  inventories – having ground production down to minimal levels during the recession – and the revival of world trade. Such factors suggest global growth could accelerate from around -1.5% in 2009 to 3.5-4.0% in 2010 – slightly above the 3.5% average experienced between 1990 and 2005.

Yet anyone expecting the global economy to take up exactly where it left off prior to the crisis is likely to be disappointed. Growth has returned, but will not mimic the 5% rates of 2006 and 2007 as several factors should serve to depress a V-shaped upturn into something much shallower.

Consumers, for one, are unlikely to revive their spendthrift habits of the boom years, suggesting that consumer spending – a key pillar of growth – could remain lacklustre. With companies liable to shed jobs for some time to come and wage growth sluggish, households are apt to be cautious, shunning the high street in favour of repaying debt and rebuilding depleted savings.

While consumers rebuild balance sheets, banks will see theirs shrinking as they recognise loan losses. A large amount of anticipated writedowns has already been recognised, but the International Monetary Fund believes a sizeable proportion has yet to be revealed, especially in Europe. Greater government regulation to prevent a repeat of the financial crisis, through measures such as more stringent capital requirements, will also act to constrain banks’ lending ability. With banks providing the bulk of credit in the economy, such limitations have obvious negative implications for growth – especially in the UK, which has a particularly heavy reliance on bank credit.

"We expect the handover of the baton of growth from the public sector to the private to be sufficiently difficult that the path of recovery proves bumpy, possibly even with the occasional quarter of negative growth."

Governments too are still feeling the after-effects of the crisis. In 2009, the turmoil forced the authorities to deliver big fiscal stimulus packages – with the US and Japan enjoying the biggest boosts to growth from such spending among the major developed economies, at 2.0% and 2.4% of GDP respectively. But the coffers are now empty and, with growth rebounding, tough austerity measures may be on the agenda in the coming years. In countries like the UK, the fiscal stimulus is to be withdrawn from this year, with tightening here likely to represent a drag on growth equivalent to 1.5% of GDP. From 2011, real spending will probably need to fall by an average of some 2% a year for five years to help plug the gap in the public finances.

Indeed, we expect the handover of the baton of growth from the public sector to the private (that is, companies and households) to be sufficiently difficult that the path of recovery proves bumpy, possibly even with the occasional quarter of negative growth. So unlike a standard economic cycle, when growth accelerates in the second year of recovery, the public-private sector transition could depress global growth towards the 3% level in 2011. In the UK specifically, the fiscal squeeze, in conjunction with the particular pressure for households to rebuild their balance sheets and for banks to contract theirs, suggests that growth will be more subdued than in most developed economies.

The investment outlook – the best may be behind us.

With a large amount of excess capacity in the global economy, inflationary pressures should remain low and monetary policy accommodative for the foreseeable future. In such an environment and with the recovery becoming more tangible, we believe that there are opportunities for further outperformance from riskier assets. That said, with the upturn in developed economies remaining fragile and the market turmoil of earlier last year fresh in investors’ minds, we expect gains in 2010 to be harder won and more limited than those of last year, with risk premiums more elevated. Within equities, returns should be driven by a focus on fundamentals, including earnings.

Asia and emerging markets – which are at the vanguard of the global upturn – provide the best prospects for outperformance, given their pro-growth and cyclical characteristics. But we believe the cyclical European markets and the UK should also stand ahead of the global average, given relatively attractive valuations. Meanwhile, the growth emphasis on energy-intensive emerging markets should also provide support for commodity prices, especially energy and industrial metals.

Within bond markets, large output gaps in the economy should rule out any real inflation threat and make it unlikely that government bond yields will rise significantly in the short term. But as the recovery progresses in the next couple of years, bond yields may then increase, buoyed further by the end of quantitative easing (QE) programmes and large fiscal deficits. Index-linked bonds, meanwhile, should continue to offer better returns than their conventional peers as commodity price rises briefly push up inflation rates, and given they offer some insurance if large budget deficits and QE prove to be more inflationary than anticipated over the longer term.