I have been advising clients for some time that the period from 2010 to 2012 will be one of fundamental change for investors as we come to terms with the new world order. In this briefing note I would like to outline our interpretation of the current economic position and how this may play out during 2010.

Current position
Leading indicators are showing a recovery in the UK and the US. Money supply has been increased by the US and European governments, the rise in unemployment has stabilised and interest rates have been kept at low levels.

Unlike previous financial crisis the US and UK governments have chosen to implement a fiscal stimulus policy to save the financial system and to stimulate the economy. This has resulted in very high levels of government debt.

In modern times it is the first time a policy of this type has been used. As to whether this kind of government intervention will work in the medium to long term is the critical question for investors.

In the short term there has been some success with this policy, financial institutions have been saved, consumer spending is still relatively buoyant and technical indicators show improvement. There is also a desire from the public to believe in a sustained recovery.

It does no need an economic expert to realise there are problems under this surface recovery.

The reality
Going back to fundamentals the demographic of the UK is one of an aging population (excluding immigration). This means the main driver of the economic boom we have experienced from the late 70’s, the consumer, is now entering a period where their spending will reduce. There are already signs of increased saving levels as the population attempts to reduce the record levels of personal debt. The natural conclusion is slowing economic growth.

Turning to the banks it is clear the public money used to rebuild the balance sheet of many banks (and in some cases to save them from bankruptcy) has not generated new lending. In the US figures show 2nd tier banks have a further traunch of home owner defaults to deal with. These repossessions are still in the legal system. These banks will need additional government support and the effects of this will ripple out to the global banking system.
In Europe banks have exposure to eastern European property debt and this has still to come to the fore. In the UK for the banks which have not been bailed out we are seeing a return to profitability, but this profit is being generated from the banks investment arm not traditional profit areas.

The increase in National Debt now at £180bn has been used to support the fiscal stimulus but it seems logical that there has to be a ceiling on what the country can borrow. In order to reduce the national debt there are only two realistic options. To increase tax revenue through a growth economy or by taxing individuals and companies at a higher rate. There seems little chance of significant growth in the economy therefore personal tax rates will rise.

In addition to raising taxes expenditure will need to be cut and this will be achieved by cutting public services.

Unemployment has been rising but the rate of increase has been slowing. The unemployment we have seen is largely private sector unemployment. Referring to my earlier point we may see over the next few year public sector unemployment, a direct contrast to the public sector growth we have witnessed over the past 10 years. The level of unemployment will again affect consumer spending and bring to a head personal debt problems.

Much has been written about whether we will see a resurgence of inflation or if we are entering a period of long term deflation. The effect of the fiscal stimulus is unknown. If we are set for a period of slower economic growth it would seem sensible to conclude that inflation rates are likely to remain low.

Investment markets
Where does this analysis leave markets? Since March 2009 we have seen consistent increases in world stock markets. The markets are anticipating a recovery and also making up for excessive undervaluation experienced from October 2008 to March 2009. It is also likely that much of the fiscal stimulus has been driven into the markets to fuel the increase in asset prices.

It seems unlikely that markets could continue at their current rate of appreciation even if we were in a period of strong economic growth.

What will happen when the fiscal stimulus ends and we revert back to fundamentals? There is every chance markets will reassess and in turn we could see steep falls.

Much has been written about the new order, the emerging countries in Asia and Latin America. These economies provide a great deal of potential and in the future countries such as India may lead the economic order. In the short term the US still provides the consumer base to which the emerging economies sell. If the US is in difficulty the global economy suffers. The challenge for the developing world will be to increase their domestic consumption to a level which can sustain growth, at this point they will take over the reins.

Decision time
Investors will need to make a choice as to where they position their assets. In normal circumstances to remain in equities without question has worked well. The short term corrections have been supported by long term rising markets so to remain invested is prudent. This time around I think we are at a critical juncture. If markets do correct to reflect the realty of our economic position they will come down sharply. It will be a correction investors will want to miss. In the long term this type of correction will represent a tremendous buying opportunity for those who have survived.

Landmarks advice is to take a defensive position going into 2010. The main objective being capital preservation. The strong performance in the 2nd half of 2009 can be consolidated and portfolios can be reinvested in lower risk assets to play a wait and see strategy. If we are wrong clients will miss out on the growth they could have achieved in rising markets, if we are right there will be a great buying opportunity ahead for those who arrive at that point with their capital in tact.

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