Investors should expect a bumpy ride in 2010

Threadneedle believes that investors have reason to feel cautiously optimistic as they look to 2010.

The company is below consensus in its economic growth forecasts for developed economies, but it expects the global economy to continue its gradual recovery over the next twelve months, helped by the superior growth prospects from the emerging economies.

"We are forecasting a low nominal growth environment in the developed world," says Sarah Arkle, Threadneedle's Chief Investment Officer.  "There is significant excess capacity in the major economies, so we do not expect inflation to be a problem - even though year-on-year energy price comparisons may lead to a short-term increase in Q1."

The company anticipates that despite the low growth, low inflation conditions there may be sporadic concerns about either inflation or deflation.  "Even though we see a period of subdued growth with modest inflation, economic data points can be volatile quarter on quarter.  As such, markets may periodically worry about either inflation or deflation and will speculate about the likely timing of a withdrawal of stimulus measures. Ultimately, however, we believe we are in a modest recovery with inflation well contained, and this is a constructive backdrop for equities."

Against this backdrop, interest rates are expected to stay low in the major economies throughout 2010, supporting liquidity at healthy levels.  However, the current extreme stimulus measures will ultimately need to be scaled back, with implications for investors.  "Quantitative easing will be reduced in 2010, and this will remove a significant buyer from government bond markets," states Arkle.  "As a result, there could be upward pressure on government bond yields".

In terms of asset classes that should do well in 2010 Threadneedle currently favours high yield bonds within fixed income:  "We like high yield bonds because of their shorter duration characteristics and the protection that the spread offers at a time when we are cautious about government bonds," states Arkle. They also like local emerging market bonds for their superior yield characteristics and also continue to favour absolute return bond funds as they can potentially make money in a rising yield environment.

Threadneedle was early to buy investment grade corporate bonds in 2009, but credit spreads have fallen a long way, creating some interesting valuation anomalies between equities and corporate bonds.  "We now have a situation where the dividend yield on many good quality companies' shares is higher than the corresponding corporate bond yield," Arkle points out.  "Asset allocation flows are likely to favour equities over corporate bonds in 2010 and we see particularly good opportunities in a number of higher-yielding equities."

Within Threadneedle's equity portfolios a major theme is the superior growth profile of the developing world.  "In countries as diverse as Brazil, Chile, China and Turkey we see growth recovering sharply from the external demand shock of 2008 and 2009," enthuses Arkle. "These economies are the mirror image of the developed world: they often have healthy financial systems and low levels of consumer debt.  With interest rates at historic lows, we believe that we are at the beginning of an extended credit cycle in emerging markets, and this creates excellent opportunities in sectors exposed to discretionary spending by consumers, financial services and real estate."

Finally, Arkle predicts continued interest in commercial property in 2010.  "We have seen a bounce back in capital values over the past few months, and this is likely to continue into Q1," she explains.  "However, over the longer term income is the main driver of property returns and, with interest rates staying low, it is income that will attract investors to the asset class," she explains.  "Yields at current levels make property an attractive option for income seekers and we do not see this changing in 2010."

In summary, despite the muted outlook for economic growth and the acknowledged risks facing markets, Threadneedle sees good opportunities for investors in the coming year but expects to see continued volatility.