The market outlook for 2010 is characterized by vast uncertainty, and investors should be prepared to reduce their exposure to risk as the first quarter progresses, according to Barclays Capital’s latest Global Outlook report.

The quarterly report outlines a number of uncertainties in the 2010 outlook, including the speed at which global economies will fully recover and the timing of monetary policy tightening.

“There is a considerable repertoire of economic and policy uncertainties that render the outlook a good deal more opaque and harder to read than usual,” the report says. “The range of possible outcomes is particularly broad.”

Barclays expects strong global economic growth in the first half of 2010, with robust growth in the United States and Europe, which have been lagging the recovery. Expansion in Asia, on the other hand, will slow significantly from its recent rapid pace, according to the report.

The second half of the year will be marked by slower growth as the recovery loses momentum, but Barclays says there is little risk of a serious growth disappointment.

Inflation risks are likely to remain muted at least for the next year or so, the report says, as excess capacity remains pervasive and inflation tends to lag the growth cycle.

In terms of monetary policy tightening, Barclays expects central banks in emerging markets to make the first move in the beginning of 2010 as inflationary pressures build in countries such as Korea and India. With the exception of Japan, Barclays expects most major economies to follow suit in tightening monetary policy throughout 2010.

The report suggests that the U.S. Federal Reserve will begin hiking interest rates in September 2010. It notes that labour market improvement in the U.S. is a key aspect of the recovery that has yet to take place, which is a necessary condition for the Fed to begin tightening policy.

“When unemployment starts falling, the course of Fed policy will be back on the table,” the report says. “This is the top intermediate-term issue we would focus on for early 2010.”

Portfolio positioning for 2010
In the first quarter of the year, forecasters at Barclays expect recent market trends to continue. They call for a “sharp rally” in equities in the first quarter, which will lead to a “decent probability” of some asset classes moving into overvalued territory.

The report notes that asset valuations have returned to more normal levels, eliminating the extremely attractive buying opportunities that existed in 2009.

“Equities, credit spreads and commodity prices for the most part seem reasonably valued,” the report says.

For the immediate future, Barclays forecasters are biased to staying long in equities. Their recommended mix of sectors includes industrials, technology, basic materials and energy. Financials are less attractive, the report warns, as banks will need to deal with a substantial increase in funding costs due to changing liquidity regulations and the ending of government guaranteed bond issuance.

In terms of geographical exposure, Barclays recommends a mix of the higher beta developing markets, such as Russia and Brazil, along with the core markets of Europe and the U.S.

But Barclays does not intend to maintain this equity exposure for long: “We are not inclined to overstay our welcome in long equity positions,” the report says. “From a tactical perspective, we would tend to reduce equity risk somewhat as the quarter progresses, shifting out of the aforementioned sectors into more defensive areas or cash.”

Following the first quarter rally, Barclays expects some sideways corrective behaviour in the second and third quarters, as investors grapple with potential policy shifts. The report warns that any sign of a shift in Fed policy toward tightening, for instance, is likely to trigger selling pressure. But the onset of such tightening will not likely trigger a bear market, since profit margins are quite high, and interest rates are coming from such extraordinarily low levels.

“Indeed, once markets price in a modicum of Fed tightening, the equity market may well start to rise again,” the report says.

For the year overall, Barclays expect much lower correlations among various assets and regions, with markets driven by a broader range of structural and intermediate-term issues rather than being dominated by the broader global financial crisis and the resulting economic cycle. The report urges investors to consider such issues as the exit strategies to be taken by central banks, the debt dynamics resulting from severe budget deficits and regulatory responses to the financial turmoil.

@page_break@In terms of bond markets, Barclays expects further credit spread tightening set against a background of modestly rising yields.

The report adds that commodity prices should move higher next year, although the rally is likely to be modest relative to the extreme volatility seen in recent years.

Overall, Barclays says its favoured asset allocation is a mix of high beta equity, cash and high yield credit.