General

Record low interest rates and good earnings are positive for equities. With the economic recovery, positive earnings leverage should continue and companies should exceed expectations. Equity valuation seems fair, especially given interest rate levels and the recovery in earnings. The recent, challenging news about sovereign solvency is a hangover of the debt crisis which has migrated from banks back to government. This year, prospects could be more challenging as investors will focus on Central Bank exit strategies. We remain cautious on bonds, as higher government debts coupled with cyclical recovery should start to put pressure on yields. Overall, the levels of government intervention and surging deficits should increase the risk premium for sovereign bonds. We are light on cash and we like short-term corporate bonds. We are positive on the US dollar in the near term while remaining cautious in the longer term. The US economic recovery should support the US dollar, while the fiscal position is a clear long-term negative.

United States

An upswing in the capital spending cycle should gradually replace fiscal policy and the rebuilding of inventories will be the main factor driving the economy forward. Indeed, the upswing in investment in equipment and software appears to be coming through more quickly than we had expected. Data on capital goods orders suggest that this will continue. Housing investment is also likely to rise in 2010 from very depressed levels. These trends should contribute to some recovery in employment and hours worked, and this should feed through to an improvement in household incomes and spending. Overall we see last year’s GDP contraction of 2.4% giving way to growth of 2.6% in 2010 and 3.2% in 2011. Overall measures of inflation have picked up sharply, reflecting swings in energy prices, but underlying trends are likely to remain muted. We continue to expect that the Federal Reserve will start to raise rates from the third quarter, reaching 1.75% by the end of 2010 and 4.0% by end-2011.

United Kingdom

The upturn in the UK economy has been disappointing so far. Headwinds to growth in the near term include the return of VAT from 15% to 17.5% and the continuing problems of some borrowers in obtaining credit. On the optimistic side, survey data point to an improving trend in export volumes and a relatively high level of investment intentions on the part of industrial companies. In other words, we may finally be seeing signs of a rebalancing of the economy away from the reliance on debt-fuelled growth of consumer spending. The switch is likely to see muted growth initially but a subsequent period of robust expansion. Overall we expect GDP to increase by only 1.6% this year but by a solid 3.2% in 2011. CPI inflation is set to exceed 3% in the near term but subdued wage growth and an end to rising import costs should see a subsequent easing. Should growth be higher than forecast we could see a first rise in interest rates in the third quarter of this year, with an increase to 1.75% by the end of this year.

Continental Europe

The economic landscape has improved sharply since the beginning of 2009, with growth of 0.4% in the third quarter, and survey evidence suggesting a moderately strong growth outturn in the fourth. Purchasing Manager surveys, along with EC surveys and a variety of national indicators, continue to trend upwards. The rate of improvement, though, has slowed and appears to be starting to stabilise. In the short run, this reflects strong fiscal support, ultra-low interest rates and a turnaround in the inventory cycle. But continued corporate profitability, along with strong corporate issuance and resilient demand, suggests that an investment-led upturn will become self-sustaining. Nevertheless, growth is likely to remain muted until mid-2010, reflecting the weakened banking sector and with continued low consumer and business confidence in the aftermath of the financial crisis. We expect the lion’s share of equity market returns over the next two years to materialize sooner rather than later.

Japan

The economic recovery appears to have temporarily stalled, but given the new stimulus package and the pickup in the global economy, the stage appears set for a self-reinforcing recovery to emerge. Indeed, Q4 GDP growth appears to have been robust, albeit a number of leading indicators rolled over at the turn of the year as the previous government stimulus package ran out of steam. However, the Asian economy is growing robustly. This, along with a turnaround in the inventory cycle and the large government stimulus, should support growth temporarily and allow a self-sustaining recovery to emerge. Resilient corporate profitability continued domestic demand and strong international demand should lead to a pickup in investment and allow a virtuous circle to develop. We expect GDP growth of 1.7% in 2010 and 2.1% in 2011. Inflation is expected to remain negative until the latter part of 2011. We do not expect an increase in official interest rates before the final quarter of 2011.

Pacific/Emerging Markets

Asian and Emerging economies were weak in January, down over 5% (in US Dollar terms). Latin America was the weakest region within emerging markets, and the Brazilian Real was weak. Russia and Turkey were the best performing markets, and Brazil and Peru performed worst. Healthcare and utilities were the strongest sectors, while financials and consumer discretionary were weakest. A variety of factors spooked the markets. Among this was China's first move to tighten policy: Chinese banks, after a significant amount of lending in January, have been told to slow the pace of loan growth. Meanwhile, President Obama announced changes to US banking regulation. Commodities were generally weak over the month in response that Chinese demand may be stifled by the possibility of interest rate increases. With China representing 30% of current global growth, investors are hoping the Chinese Central Bank can deflate the massive property bubble before it bursts.

Bonds

Government bond markets continued to appreciate into 2010, yet the outlook for issuance has not eased and remains a threat for the future as solvency issues among countries are increasing. We expect yield curves to remain steep for a considerable time. We continue to recommend a well-diversified fixed income portfolio, carefully selecting the best sovereigns, the safest part of the credit market, and maintaining an emerging sovereign bond market exposure where possible. Over the past quarter, a diversified approach outperformed in relative terms; however, we believe that 2010 will see risk increase in sovereign solvency. We thus recommend maintaining a low duration to government bonds with long positions into investment grade corporate credit and sovereign emerging bonds. We are also concerned about higher rates on a long-term horizon.

Currencies

The US dollar continued its rise against virtually all of its rival currencies as investors took the view that the US economic recovery in 2010 would likely be stronger than in Europe or Japan, prompting dollar buying. Much of the US dollar’s rally is likely to happen ahead of the Federal Reserve (Fed) actually raising interest rates. Indeed, history has shown that it is not so much the action of Fed tightening that boosts the US dollar, but rather the anticipation of a turn in the US rate cycle that has proved to be the most beneficial for the US currency. Although the US central bank is not expected to amend its monetary policy anytime soon, speculation of an upcoming FOMC statement language change, together with the withdrawal of emergency liquidity measures by the Fed early in 2010, would lead to more aggressive expectations of monetary tightening. Emerging Market currency returns should remain reasonably strong and are likely to be a sizeable contributor to the performance in US dollar terms of several major EM equity markets.