As we feared 2010 is a more difficult year for investors. It is not clearly a crisis year like 2008, nor clearly a sharp recovery year for financial assets like 2009. Markets are jittery, and governments are unsure about what to do.
The world is still badly divided. There are the successful exporters, led by China, Japan and Germany, and the heavy importers, led by the US and the UK. The former need to import more and consume more at home, the latter need to export more and consume less. There are limited signs that the US and UK will export more following devaluations, but little sign of a surge in imports into Japan and Germany.
There are the fast growth countries, led by China and India, where inflation is becoming a problem, such is the strength of their stimuli and recovery. There are the low or no growth economies led by the UK, but including Japan and Euroland.
The divisions are no longer clear cut. All the world’s major economies face a range of difficult problems. We can perhaps best identify them by looking at several issues.
Firstly, there are those countries that have inflation problems. India has a serious problem, with a 16% rate. China has sharply accelerating inflation. So does the UK, but the authorities think that will prove temporary. The usual policy response to higher inflation is higher interest rates and monetary tightening. China has just hinted at this. She will do more, but I suspect she is also very afraid of tipping the economy back into downturn by doing too much. She will probably do more by way of controlling the volumes of bank lending to various sectors. India needs to do more more rapidly. The UK is likely to be less aggressive with its loose money policy from here than over the last extended period of quantitative easing, despite the poor performance on growth.
There are also countries like Japan that have deflationary problems. A shortage of domestic demand is keeping prices well down. Demand is also depressed in core Euroland. The normal response would be to spend and borrow more. Unfortunately for Japan past governments have done lots of that, but it has not succeeded in expanding demand to lift the economy out of torpor. It has left the economy heavily indebted. Germany is philosophically ill disposed to borrowing more to fire consumption. The Euro bank seems keener to relax by allowing some modest devaluation, to make German and other EU exports more competitive again.
There are highly borrowed countries including the US, UK and Japan which would like more activity but have to acknowledge there are limits to how much their states can borrow from here. Both the US and UK will have to commence deficit reduction programmes soon, whilst Japan will probably pause before another surge in government borrowing, as it has not worked in the past.
So we have a recipe for world stagflation. The hot areas will have to cool down a bit, whilst the cold areas each have problems with administering more stimulus or finding one which might work.
We expect a fitful and slow recovery overall. India and China will head the growth tables amongst the larger countries. The US, and more especially the UK, Spain, Ireland Iceland and Greece, will have to squeeze their public sectors to control their state debts.
Australia has led the way with higher interest rates. There are likely to be higher interest rates in India and Korea, monetary tightening in China, and market forced interest rate increases may continue in the UK as quantitative easing ends.
The best policy mix would be easy money and lower public deficits, to stimulate growth. This will prove elusive as a formula for many territories. The banks are making good money again out of the extraordinary conditions, but banking regulators are still tightening around the world, often offsetting the other expansionary measures taken by governments. If governments are serious about another round of bank bashing because it is such good politics, it could restrain lending and demand more.
We still recommend balanced portfolios for these more difficult conditions. It is going to be much more difficult earning good returns than it was in either 2008 when cash was so attractive, or 2009 when shares were cheap. We favour the emphasis on assets that offer reasonable income, including good quality corporate bonds and property. Although Asia has its problems, they are the problems of recovery rather than the problems of past excess and slow growth, so we still prefer that area for the equity exposure in growth-oriented funds.