The recovery year

2. Stronger growth in the emerging world. Thanks to stronger domestic demand and less in the way of structural constraints such as debt and demographics, growth in the emerging world is likely to be 7% compared to around 2.5% in advanced countries in 2010. China is likely to grow by 10%, India by 8% and Brazil by 6%.

3. Benign inflation. Inflation lags economic activity because it reflects capacity utilisation, which is below normal well into an economic recovery. This time is no different except that excess capacity is greater than normal, with the result that underlying inflation is likely to continue to fall in the year ahead.

4. A gradual move to wind back the stimulus. Along with the economic recovery there will eventually be pressure to wind back budget deficits and raise interest rates. Talk of higher interest rates and uncertainty about how aggressive the wind back will be, will no doubt fuel occasional corrections in asset markets over the year ahead, particularly in those markets that have benefitted the most from low US interest rates. Namely, emerging markets, commodities and commodity currencies – much as occurred in 2004 when the Federal Reserve (the Fed) last moved to tighten. However, tightening will be a very slow process in advanced countries, given memories of premature tightening in the US in the 1930s, still very high unemployment, and falling underlying inflation. Global central banks will first move to unwind the liquidity stimulus before starting to raise interest rates during the second half of 2010. Interest rates will still be very low by the end of 2010 – maybe around 1.5% in the US. China is likely to move a bit more aggressively to tighten, but it is not as dependent on stimulus measures.

5. Earnings recovery. As the economic recovery becomes entrenched, earnings growth will return and take over as the key driver of share market gains. Profit growth is likely to be in the order of 20% in the US and Australia, and 30% or more in emerging countries.

6. Australian economic growth to rebound but underlying inflation to slow. The rebound in business and consumer confidence, a housing construction recovery, numerous mining projects, and increased public infrastructure spending are expected to underpin GDP growth of around 4% through 2010.

This is likely to see unemployment return to around 5.5% by year-end. Inflation is likely to be 2.5% thanks to a combination of global excess capacity and the impact of the strong Australian dollar.

While the RBA will continue to raise the cash rate, the process is likely to be gradual, taking it to around 4.75% to 5% by year-end, with low inflation and additional increases in bank lending rates stopping a more aggressive rise.

Looking at the major asset classes for the year ahead:

• Share markets are likely to rise further, thanks to the combination of improving economic and profit growth, low inflation and sustained low interest rates at time when there is still plenty of cash on the sideline. However, shares are moving from a multiple driven phase to an earnings driven phase. This, along with moves towards higher interest rates, will likely result in more volatile and constrained gains than has been the case since March. The Australian ASX 200 and All Ords indices are expected to rise to around 5600 by the end of 2010 and we see Australian shares continuing to outperform traditional global shares, reflecting their higher dividend yields and stronger growth prospects.
• Asian and emerging markets are likely to remain out performers reflecting better growth prospects. However, the ride will be more volatile.
• Commodity prices and the A$ are likely to remain solid off the back of the economic recovery, with the A$ breaching parity.

However, expect occasional sharp corrections when the Fed moves towards tightening.

• Cash remains unattractive, reflecting low interest rates. Cash returns are likely to be around 4.5%.
  Government bond yields are likely to push higher later in the year as monetary tightening starts to be factored in. Corporate debt is far more attractive with yields of 7.5% or more.
  
• Unlisted non-residential property is likely to see positive returns on the back of yields of around 7% and modest capital growth. This is thanks to more favourable space demand/supply fundamentals, less selling pressure and increased investor demand.
  
• Average house price gains are likely to slow as mortgage rates rise and the first home owners boost comes to an end. A stronger labour market will provide some support though.
  
• Overall, expect average house price gains of around 5%.

Our return expectations imply that most super funds should see continued gains through 2010.

US consumers and premature tightening are the main risks

The two big risks are that US consumers return to cutting spending and paying down debt and/or that policy makers start tightening too aggressively, too early. However, a stronger labour market should help US consumers. It also seems that policy makers are keen to avoid a re-run of Japan in the 1990s and the US in the 1930s, when policy was tightened too aggressively. China is also worth watching.

The last year has told us that just as the investment cycle goes down, it also goes up. Right now, it is still early days in the upswing and so growth assets, like shares, are likely to continue to do well over the year ahead.

Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.