Emerging markets to lead in 2010, bonds decline

Investment returns for 2010 will be driven by three factors—corporate earnings, inflation and policy decisions—according to global asset manager Standard Life Investments. Interest rates will remain at historical lows as policymakers try to stoke the economic engine.

“Inflation will remain a problem for many central banks in 2010,” says Andrew Milligan, head of global strategy at Standard Life Investments. While core inflation will remain low, “temporary factors” may cause spikes in headline inflation rates.

“Weak underlying inflation reflects the sizeable amount of excess capacity, such as double digit unemployment rates,” he says speaking from the U.K. perspective. “2010 looks set to be a year of the ‘jobless recovery’, similar to the early 90s, good for corporate profitability but a noticeable headwind for consumer demand.

“Further ahead, inflation remains a risk for investors if central banks and governments do not successfully manage the withdrawal of excess liquidity from the financial system.”

Cheap money will not only fuel inflation, but force income investors further out on the risk curve.

“Government bonds remain attractive while inflation is low, although the implications of the quantitative easing and rate decisions will eventually prove a major headwind,” Milligan says. “After most OECD recessions, the first year or two of recovery normally see a very sharp recovery. On this occasion, 2010 is not expected to be a year of above trend global growth.”

While corporate profits will grow, Milligan questions whether that growth will keep pace with market expectations.

“Analysts are forecasting earnings growth up some 20-25% over the coming 12 months. The key issue for many companies and stock markets is their exposure to the faster overseas parts of the global economy rather than slower growing domestic earnings.”

He points out that roughly two thirds of U.K. equity market profits come from overseas.

A better bet might be to cut out the middleman, and invest in the emerging markets themselves, which are primed to post the best returns once again, according to UBS Wealth Management Research.

As an asset class, emerging market equities should deliver total returns in the neighbourhood of 15% over the coming year. In comparison, developed markets are expected to return about 10%, including dividends.

“In Wealth Management Research’s view, favorable valuations suggest that investors should remain exposed to corporate securities at the beginning of 2010,” UBS said in a report. “As the year advances, it will be important to determine whether earnings have truly embarked on an upswing.”

The strong economic performance of the emerging markets will boost commodity prices, which UBS also points to as a diversification play.

As most commodities are globally priced in U.S. dollars, rising prices could force the greenback lower.

The global recovery should continue, the bank’s research team suggests, but it will be a “bumpy road.” Central bank rate hikes are inevitable, but their timing will be critical in avoiding further financial market setbacks.

Government bonds are expected to disappoint, and UBS recommends reducing portfolio exposure, especially in the case of long-dated bonds. For risk averse investors, investment-grade corporate offerings should provide a better returns with only marginally greater risk.