>First quarter 2010: 2010 to be turning point for world economy (LLOYDS TSB)

In this, our inaugural World Economic Quarterly (WEQ), we focus on the G10 and E10 countries. Our G10 and E10 groups are defined as the top ten countries by gross domestic product (gdp) in each segment. The rest of the world is also analysed, but in less detail. Our approach is to recognise that investors want to focus on the fastest growing, and largest, of the world’s economies, but at the same time not lose touch with what is occurring in other parts of the world. Many countries in the latter are also fast-growing and are as instrumental in the reshaping of the world economy that is underway.

Two decades or so ago, the developed economies accounted for over two-thirds of global gdp, by
2006 this fell closer to one-half and on current trends it will fall to around one-third by 2020. That is a measure of the pace at which the global economy is evolving and why there needs to be focused research and analysis of the opportunities and challenges this opens up for companies. In this publication, we focus on the economic and financial market implications of this rapid change over the next two years.

The overall theme is that 2010 will be a year of global economic recovery after the deepest downturn since the Great Depression. However, the effects of the policy loosening that has led to
recovery will also be felt for many years.

Financial market themes in this Quarterly

1. US dollar to rally against its main trading counterparts
Among our G10 advanced economy grouping, we look for the US to record the fastest pace of economic growth in 2010. A more rapid closure of its output gap should see the US Federal Reserve raising interest rates well before the ECB, BoJ and BoE. This is likely to support the US dollar going forward. In addition, we feel that the dollar will soon start to benefit from stronger US economic fundamentals as the theme of a dollar-positive response to risk aversion fades on a better-established global recovery.

2. Emerging Asian currencies to extend gains in 2010
The main impetus to global economic recovery will continue to come from emerging markets in 2010, notably in emerging Asia. Assuming only a limited risk that activity in China slows in response to rising bad debts after the recent surge in bank lending, the orientation of emerging East Asian economies towards export-led activity should propel global growth. Relatively faster growth and accelerating inflation pressures (related to rising commodity prices) should see some emerging market central banks raise interest rates from early 2010, benefiting their currencies. But some (East European) emerging markets are in a different position, with interest rates likely to be lowered further now that the risk of currency collapse has been reduced (often as a result of IMF bail-outs). Hungary is one such example.

3. Divergent economic performances to keep volatility high
Notwithstanding our central view of a return to global economic growth, starkly divergent performances across countries will almost certainly feature in 2010. This may be a source of uncertainty and volatility in financial markets. As noted above, some emerging market economies - particularly those dependent on external financing - may experience difficulties in the form of additional currency weakness and/or higher bond yields. Equally, confirmation that the rally in ‘riskier’ assets seen since March is sustainable could fuel a further rebound in equities and commodities with government bonds falling out of favour. Given the challenging fiscal backdrop in many countries at the moment, rising government bond yields and tougher financing conditions represent a potentially significant downside risk to the global outlook.

4. Inflation pressures of increasing concern for central banks
At first glance, the excess spare capacity created by deep recessions in various economies points to subdued inflation pressures going forward. In economics jargon, aggregate supply exceeds aggregate demand. But under these conditions, inflation pressures will only be muted if inflation expectations are under control. At the current juncture, there is a risk that these expectations start to become elevated. First, inflation rates in many countries are poised to accelerate in the short term as energy price declines in the previous year fall from the annual comparison. Second, central banks around the world may keep so-called ‘unconventional’ monetary policy measures in place for too long (or unwind them too slowly). And third, the nature of the economic and financial crisis means that supply potential in many countries will have been partially destroyed, so adding to inflation pressures. All of these indicate potentially significant upward pressure on government bond and swap yields over our forecast horizon.

5. De-leveraging holds the key for the US dollar longer term
While our central view is for the US dollar’s trade-weighted exchange rate to appreciate into next year, the medium to longer-term outlook may be rather different. If private and public sector de-leveraging is too slow (or non-existent), the US will run large current account deficits well into the future - a structural drag on the US dollar. Our latest forecasts show the US current account deficit narrowing to 3.2% of gdp in 2009, from a shortfall of 4.9% in 2008 but then widening back to a similar level by 2013. Given that progress is likely to be only gradual, it is not inconceivable that financial markets turn their attention to the theme of wider external deficits quite quickly.

To read the full report: FIRST QUARTER 2010