Narrator – Claire Evans, Marketing Director, Unit Trusts
Recorded date – December 09

During the recent crisis, four key things have helped to drive the performance of equities. That’s government or central bank policy, economic growth, inflation and valuations. In May 2009, all of these things were supportive of a continued rise in equity prices. Now however, there is uncertainty surrounding how much longer governments can maintain such accommodative policy measures, such as low interest rates and quantitative easing, and whether the improvements in economic growth that have begun to emerge can be sustained through next year.

During the recent downturn, governments and central banks have introduced a number of initiatives to try and boost liquidity, which is the amount of money within the economy. A prime example of this is the Bank of England lowering interest rates which in theory makes borrowing cheaper, and its policy of quantitative easing, using newly created money to buy financial assets such as government and corporate bonds. This in turn means governments and corporations have more money to spend elsewhere. The view of our economists within Legal & General Investment Management is that the critical factor for financial markets going forwards will be policy and in particular how they cope with the removal of these initiatives.

This is however a short term policy and central banks are starting to remove liquidity from the system, in effect causing an extra layer of uncertainty for financial markets. Our economists' view is that a self sustaining recovery will only be evident if growth continues to improve at the same time as liquidity is removed from the global financial system.

Our economists have assessed the mix of global economic data and two clear themes arise; emerging versus developed markets and manufacturing versus the consumer. Let’s look first at emerging markets versus developed markets.

It’s our economists' view that developed market economic data will start to lose momentum over the coming months, therefore developing economies will play an important role in underpinning the hopes of a global economic recovery. Our economists forecast higher economic growth in the developing world when compared against the consensus view from industry experts. So far economic growth in the region has held up well.

Turning to manufacturing versus the consumer. In the US figures from the Institute of Supply Management, which are a key indicator of the health of the manufacturing sector, have seen a rapid improvement since the beginning of this year. The current reading indicates economic expansion. This is also reflected in UK figures. However, our economists believe these figures could start to stabilise over the next couple of months, which could prove an issue for the equity market as manufacturing data has to date helped to fuel the recovery witnessed since March 2009.

In contrast consumer data has been disappointing. Although in the UK consumer confidence has recently started to pick up, in the US it has shown little sign of improving. However, with prices for commodities, such as the price of oil, and imported goods expected to get higher and wages not expected to rise by much, it is unlikely there will be much increase in spend by consumers, both in the US and the UK.

When equity values were low back in March 2009, it was easier for financial markets to rally on the back of hope over the recovery. Now, with values higher due to the rally, the market will need to see evidence of the economic recovery before it will be willing to pay a higher price for equities based on its future profits.

Our economists' view is that equities will be relatively flat going into year end (2009). However, the sensitivity of markets to news, such as the recent issues in Dubai, will play a big role.

One bright spot for equity investors comes in the shape of dividends. One year ago we were very concerned over the path for dividends. The dividend yield on the market was looking attractive at around 5%, however our economists' view was that this level of yield was not sustainable.

Since the end of 2008, the level of dividends for the UK market has fallen by 20%. Our economists now believe the majority of dividend cuts are behind us and that earnings will start to recover. Therefore the majority of companies will be able to honour their dividend commitments. This supports investing in the typically higher dividend yield markets globally, such as Europe and the UK.

To summarise our economists' view I would say that we are reaching a critical point for financial markets as policy makers decide how to respond to economic news over the coming months. We are moving from a period of hope to a need for delivery as growth expectations have been revised up in recent months.

Equity markets will therefore likely pause for breath to analyse the mix of economic and corporate news, in order to take a view on potential long term growth.

Equities offer an attractive yield compared to other asset classes, such as cash, bonds and gilts. Our economists believe that these yields are now sustainable. However there may be an increase in equity market volatility next year as investors weigh up the effect changes to policy, like the Bank of England stopping quantitative easing, will have on growth. This is a risk investors need to be aware of for 2010.