As we look ahead to 2010, Jenny Lowe reveals what fund managers and analysts are predicting for the economy.

The world’s major central banks have run aggressively easy monetary policies since the onset of the financial crisis last year to forestall the risk of a downward spiral into deflation.

To date, this stance appears to have worked, and the debate is now gradually shifting towards the formulation of monetary stimulus ‘exit strategies’.

‘In most countries, there is little sense of urgency,’ says John Stopford, manager of the Investec Sterling Bond Fund. ‘This is because the recession has created a significant amount of spare capacity that should tend to keep core inflation under downward pressure for some time to come.’

Recent decisions, however, to raise interest rates in Australia and Norway, as well as the expiry of some of the US Federal Reserve’s unconventional policy programmes, suggest that the process of policy normalisation is already under way.

Stopford adds, ‘The speed and extent of tightening will vary by country. In particular, the perceived amount of economic slack and the pace of recovery will be key considerations. In addition, central banks will try to balance the risk of removing stimulus too quickly against the need to move policy gradually to a more neutral setting.’

Rocky roads
This year has certainly been anything but an average one for the UK market, as Ben Russon, the long-serving manager of the Newton UK Opportunities fund, points out: ‘Interest rates plummeted to new depths, the economy has experienced its longest period of contraction since the Second World War and equity markets have bounced over 50 per cent from their March lows.

‘Meanwhile, record rights issues and savage dividend cuts were also witnessed across the board. These extremes resulted from a multitude of factors, many of which will continue to exert an influence on 2010.’

However, Russon warns that 2010 will bring with it a host of new market forces to consider, suggesting that ongoing corporate belt-tightening will feed through to further increases in unemployment and muted wage growth. ‘Regardless of the election result, the incoming party will have few options. Unless a credible plan is laid out
to get the public finances under control, sterling and UK gilts will suffer.’

Out with the old
From an investment perspective, the possibility of a new government slashing public spending would create considerable drag for the domestic and consumer-focused parts of the market, such as banks, retailers and leisure companies.

‘Although the emergency stimulus measures have managed to stabilise the UK economy, it’s still far too early to suggest that this marks the beginning of a new era of economic expansion, in which the world bounces back to how things were before the credit crisis hit,’ says Russon. ‘Unfortunately, simply piling on public debt to plug the hole created by the withdrawal of private borrowing doesn’t provide a substantial basis for economic progression.’

Asbhurton’s manager of asset allocation and strategy, Tristan Hanson, refers to the current economic situation as the ‘sweet spot’. This, he says, has two elements – economic growth and low interest rates – and therefore also has two opposing risks.

First, there is the concern that the structural difficulties facing Western economies – notably, high public and private debt levels, impaired banking systems and high unemployment – are simply too great for a robust recovery to take hold.

Alternatively, it is not growth but rather prolonged low interest rates that are unsustainable. He says, ‘As the global economy recovers, concerns about inflation and asset price bubbles will provoke central bankers into taking away the punchbowl earlier than most investors anticipate. A material rise in commodity prices could heighten fears of rising inflation and amplify the risk of interest rate hikes.

‘Investors must prepare themselves for a period of either higher interest rates or disappointingly weak growth. This will mean bumps in the road. However, in our view, the general backdrop for financial markets is likely to remain relatively benign for some time to come – a global recovery is under way and monetary policy will remain accommodative.’

Go east
But as the UK economy is likely to face anaemic growth over the next few years, constrained by debt, healthy growth is predicted for the global economy, led by emerging markets such as China, India and Brazil. All are undergoing industrialisation that is driving industrial and consumer demand, and Richard Plackett, manager of the BlackRock UK Special Situations Fund, believes that investors should ‘look through’ the moribund UK economy to small- and mid-caps that are exploiting demand overseas.

‘The small- and mid-cap area of the market is a fertile hunting ground for stocks that have little or no exposure to the
UK economy. The weak pound benefits these companies as their products and services become more competitively priced. However, given the sheer volume of small- and mid-cap stocks, the identification of those companies with strong growth potential has arguably never been more important,’ says Plackett.

‘Companies with export earnings in resources, industrials and technology are particularly attractive, in contrast to those exposed to tightening UK government and UK consumer spending. Over the next few years, companies exposed to overseas markets are likely to perform better than those whose activities are restricted to the UK economy.’

He adds, ‘The UK stock market is diverse and international. It is also the world’s third-largest stock market, with almost 70 per cent of earnings from quoted companies coming from overseas. Our focus is on well-capitalised companies with strong balance sheets. Industrials, commodities and technology are areas that look set to take advantage of a market upturn.’

But Ramon Pons, head of credit strategies at Matrix Money Management, questions whether the best opportunities for investors are in alternative credit funds.

Falling prices
At the beginning of 2009, corporate bonds looked extremely attractive, with low prices and high yields of over 20 per cent. Pons explains, ‘Throughout 2009, bond funds have seen record cash flows from retail investors and delivered excellent performance, but corporate bond prices have rallied and prices now have further to fall if either a company’s fundamentals or economic fundamentals turn out to be weaker than expected. So from here the opportunity for upside seems limited.

‘The long-only bond party may now be ending, and with corporate bond yields falling to pre-Lehman bankruptcy levels, there may be downside dangers to holding bonds. We believe that diversifying into alternative credit funds may benefit investors.

‘It may seem counterintuitive to traditional investors but alternative fund managers who invest in bonds actually like recessionary environments as they provide lots of opportunities to make good investment returns.’

Legal & General’s credit strategist, Ben Bennett, agrees that there are some important events that could prove supportive for corporate credit risk. ‘Very soon, corporate default rates will have peaked and will steadily decline. While they will be coming from a very high level, this topping out will at least provide some welcome visibility of the current credit cycle. In addition, the monthly net change in US jobs may improve to zero around the turn of the year. Again, this does not sound like much to get excited about, but heavy job losses this year have represented a potential catastrophe for a wide variety of asset classes such as credit cards, mortgages and any company linked to consumer expenditure.

‘In addition to these events, we also do not expect the liquidity taps to be turned off for some time to come. While momentum behind the high yield part of the credit universe may peter out and even reverse at some point in 2010, for now the current backdrop of low interest rates and easy liquidity should allow companies to obtain financing, and investors to hunt for yield.’

Seeking better investments
As investment-grade yields contract in line with the burgeoning economic recovery, investors are faced with a choice of accepting the lower income on offer or switching into riskier assets to try and maintain returns.

Max King, strategist at Investec Asset Management, says, ‘We remain strategically very positive on risk assets but are more cautious in the short term. Markets have run strongly since their March 2009 lows and a pause at least has always been likely at some point. The US dollar has been negatively correlated to movements in equity markets in recent years, making it unlikely that equity markets would advance in the face of a dollar rally, which was looking increasingly likely. Finally, while we believe that a long and steady economic expansion is positive for equity markets, markets are undeniably negatively influenced by poor economic data in the short term.

However, King also notes that valuations are improving, with the global price-to-earnings ratio at 18 times on 2009 earnings but below 14 times on 2010 earnings. ‘Earnings growth is now expected to be -8 per cent in 2009 but +30 per cent in 2010, with over 60 per cent of changes to analysts’ estimates now positive.

‘US third-quarter earnings have been nearly 17 per cent ahead of forecasts, similar to the exceptional overshoot seen in the second quarter of 2009.’

He concludes, ‘We believe there is still opportunity in medium-quality and high-yield bonds, and emerging markets debt remains attractive. Corporate bond returns are expected to remain significantly ahead of those on government bonds and this view is reflected in our bond portfolio. Overall, we continue to expect good absolute and relative returns for at least the next year.’