Outlook for 2010

• Introduction
• G7 fiscal initiatives key to global economy
• Credit premiums not factoring in all risks
• Short term peak may not be far
• Rental weakness likely to endure
• Commodity market support from China
• Dollar to suffer, Asian currencies to be strong
• Focus on diversification

 Introduction

Growth momentum will slow in 2010 but should remain positive, the balance of growth will shift eastwards and diversification into real estate is appealing.

According to the IMF, the world economy is set to grow by 3.1% in 2010. This is not exceptional compared with recent years, but what is unusual is the regional contribution. Asia and some of the Latin American emerging countries should provide the greatest impetus.

A combination of buoyant commodity prices, substantial public expenditure and loose monetary policies has boosted prospects in these regions where the impact of the financial crisis was less severe, and in some cases almost nonexistent. Growth is set to bounce back vigorously from the dip seen this year. Countries such as Malaysia and Thailand should achieve 5-6% GDP growth in 2010 and Latin American and Eastern European economies are following a similar path.

 G7 fiscal initiatives key to global economy

Notwithstanding the outlook for Asian and emerging markets, the strength of the global economy in 2010 will be dependent upon fiscal initiatives amongst the G7 as government debt profiles move up the political agenda. G7 countries will be constrained by persistent issues within their banking systems and fiscal probity. But, on balance fiscal support should sustain some momentum as private sector demand does not yet appear to be wholly self-sustaining. employment continues to be an issue for consumer confidence within the G7, although the offset to the swift rise in unemployment has been profit margin improvement.

The drop in output that the global economy experienced has not been fully recovered implying large gaps in output and minimal inflationary pressures next year. This will give monetary authorities a green light to sustain exceptional accommodation which some indicate is their intention. Liquidity in the financial system in general should remain abundant lending a supportive backdrop to financial markets, but quantitative easing may be relinquished as a tool to further improve the monetary environment.

 Credit premiums not factoring in all risks

In the government bond market, longer dated US, UK and Eurozone yields should continue to trade in a broad range of 3-4%. The rapid recovery in credit markets has recently showed signs of slowing. Whether this is a brief pause before further spread compression or the start of a correction is uncertain. We continue to see some risks to the recovery and in our view tight spreads prevailing in industrial credit are insufficient to compensate for the risks ahead. Emerging market debt spreads have also compressed further. The underlying credit worthiness of emerging countries continues to improve and risk premiums should continue to narrow into 2010.

 Short term peak may not be far

Equity markets have experienced extraordinary performance since March 2009 and as a result valuations that had been cheap have re-adjusted. Stocks are currently fair value based on consensus forecast. Progress from here will depend on top line growth and suggesting the ‘easy’ returns have already been made. Nevertheless, we do not expect the economy to sink back into recession in 2010, so there will be some degree of revenue improvement. In terms of short term outlook, risk appetite indices are in near ‘euphoric’ territory, so we may not be far from a short term peak in markets.

 Rental weakness likely to endure

There has been some stabilisation in tenant demand in real estate and a consequent reduction in the pace of rental decline during the third quarter. This weakness is likely to endure into 2011. On the positive side there have been pockets of strength in capital values in Western Europe and Asia Pacific.

In Asia, occupier markets are closest to reaching a turning point as economic activity has strengthened but an abundance of liquidity is likely to be the main factor supporting values. Capital values are down a sharp 40% from their peak in the US. However, the correction is nearing an end, with support coming from a historically high investment yield premium to government bonds and Federal Reserve aid for the CMBS market in the face of rising roll over risk.

 Commodity market support from China

Oil prices have come under short term pressure following the Commodity Futures Trading Commission’s (CFTC) focus on speculative positioning in commodity markets. The outcome of the CFTC’s deliberations could prove pivotal in shifting commodity trading outside of the US which may have consequences for price volatility. Persistent demand from China and developing countries should support the market longer term.

 Dollar to suffer, Asian currencies to be strong

The correlation of exchange rates with equities and credit has changed somewhat. The US dollar continues to suffer as risk appetite increases, but the yen has also strengthened, contrary to its performance during the crisis. Sterling has joined the ranks of the weaker currencies, despite it being undervalued against the euro on a purchasing power basis. This is unlikely to change until the policy environment improves. Asian currencies should continue to find buyers whilst upwards pressure on short rates prevails, and portfolio flows into the region persist.

 Focus on diversification

The relative performance between risky and non-risky assets is approaching an extreme, raising the prospect of some consolidation or correction before the year end, but we don’t expect this to be acute. This potential scenario heightens our focus on versification, and consequent attraction to real estate. We now believe it appropriate to commit funds to this asset class, particularly the UK where the current weakness of sterling lends it even more potential.