Is there hope for the 'English Patient'?

Yes

James BevanHead of investment at CCLA

It is popular to assume the UK will have a more than difficult economic time this year. But these forecasts of gloom and doom are somewhat overdone.

Taking a global view it looks as if economic momentum is re-accelerating, and that global GDP growth will be 4 to 4.5 per cent in 2011. This prospect is supported by Global Purchasing Manager Indices while companies appear to be under-invested, with free cash flow at a record high. A key issue is that half of global GDP (on a purchasing power parity basis) now comes from emerging markets and while we expect Chinese headline inflation to accelerate, core inflation is modest, while export prices are not rising. Also, despite the much vaunted housing bubble, the Chinese house price to post-tax income ratio is very similar to the UK.

The doom-mongers seem to forget that economies and markets are connected, and the current climate of abnormally low real bond yields helps government funding arithmetic considerably and pushes down the savings ratio. Meanwhile, it may well be that QE2 in the US is more effective than investors expect, by reducing real bond yields, by de facto exporting QE and creating a non-Japan Asia liquidity bubble, and by allowing politicians to postpone fiscal tightening.

We expect the Fed to be on hold for the next few couple of years, holding down bond yields, and core inflation is set to fall in the near term (owing to the size of the output gap). This background is good news for equities, which offer better value than all other major assets classes.

We may have a new bear market when QE ends, if/when money rates rise aggressively, or labour gets pricing power. But in the near term, none of these look likely in the UK and we can protect value with a focus on decent free cash flows and high and growing returns on invested capital to fund sustainable real dividend flows. These should be the key UK-related investments.

The risks attached to credit availability and credit costs call for caution on equities of highly leveraged companies and those experiencing margin pressure, with competitive pressures likely to intensify as recovery continues.

No

Stefan KellerHead of MAP research and external relations at Lyxor Asset Management

Economic uncertainty has declined significantly on a global scale since the Federal Reserve committed last summer to provide additional monetary accommodation through unconventional measures to avoid a double-dip recession in the US. It comes as no surprise that the UK stock market has been – and should remain – one of the main beneficiaries of the global reflation trade: the Top 10 stocks of the UK FT-SE 100 index account for nearly half the market capitalisation, but more than three-quarters of their revenues are generated outside the UK.

So far for the good news. The start of the year gave fresh evidence that there are positive stories in Europe, but the UK economy is not one of them. The government is implementing the largest fiscal squeeze since WWII to tackle the record deficit of the country.

The consequences of austerity will be felt as soon as this year, and it will be a marked economic slowdown: house prices have started to drop again, manufacturing output softened at the start of the year, and low rates have prompted neither supply nor demand for credit.

Fears that inflation will be higher for longer than expected have pushed market participants to become increasingly aggressive in their pricing of BoE interest rate increases. UK inflation has been above the 2 per cent target for approximately 80 per cent of the last five and a half years. A marked sensitivity to interest rate rises could weigh further on household spending as UK household’s financial liabilities still represent 151 per cent of their gross disposable income. Clearly, concerns about balance sheets pose a downside risk to consumption.

The lessons in terms of asset allocation are straightforward. In the context of above-target inflation and a grim fiscal outlook, positive total returns on gilts, if any, are likely to be entirely carry-driven in 2011. On the other hand, a rebalancing towards risky assets, in particular through blue chips geared to global growth rather than domestic demand, would make sense.

Any rescue plan for the ailing patient should be bold. And why not take market participants by surprise? As the UK’s major trading partner, the euro area represents 43 per cent of UK goods and services exports – what if Prime Minister David Cameron's government would start considering entering the euro zone?