This time last year markets were still in freefall after the bankruptcy of Lehman Brothers and the collapse of Fannie Mae, Freddie Mac, and AIG in the US and our own banks -- RBS and HBOS. By March 8, 2009, the S&P500 (the index of America’s 500 largest companies) was down 25% year-to-date and 58% from its peak (the FTSE100 was -65% in US$ from its peak but sterling devalued, making the decline less painful for sterling investors).

The news was grim but it wasn’t fear of recession which produced a 58% decline in share prices -- it was fear of deflation. This recession was different from all other post-Second World War recessions (as Alistair Darling kept telling us) because it included the risk of deflation. By March, the markets were pricing extraordinary levels of deflation into shares and bonds -- a Great Depression II.

But the system survived, largely due to a tsunami of central bank liquidity equivalent to 19% of GDP, and the decision by China, India and Brazil to fill the vacuum left by the exports collapse with domestic consumption. Looking back on 2008-2009 we now know the world was saved from disaster by this massive transfer of private-sector debt to the public sector. Unfortunately, this has left a number of countries with debt obligations of post-Second World War levels. Bloomberg estimates the US will run fiscal deficits equal to 10.4% of GDP this year and 11.6% next year. The UK is at 12.5% and 13%. This will at some stage become a headwind for bond and equity markets, but more on that later.

How about 2010? Stock markets have recovered strongly from the March lows and rose above pre-Lehman levels. Here are some scenarios as to how this will pan out.

 

1. The 2004 scenario: a year where markets rose modestly following the sharp recovery rise in the previous year.

I tend to side with Brewin Dolphin chief strategist Mike Lenhoff, who has a 2010 target for the FTSE of 5500. I think 5800 might be doable, but neither of us is expecting a strong 20%+ year for stock markets. As the global economy continues to recover led by the US (China has already recovered), policymakers will look to tighten monetary policy. This has the potential to unsettle investors as markets anticipate less stimulus and higher interest rates. I would expect short interest rates to stay during 2010 unless inflation rises more than expected, but the stimulus withdrawal would probably have an impact. This doesn’t necessarily mean markets will correct a lot, but they may be range-bound for a number of months before investors see employment and demand improve. I’d rate the probability of this scenario at 35%

 

2. The 1994 scenario: economic growth is far stronger than most expect.

While most investors do not expect a strong recovery, a V-shaped bounce-back like that of 1975 has been the norm for post-Second World War recessions: 1954, 1958, 1974 and 1982. The exceptions were shallow recessions like 2001. The notion that the magnitude of the recovery should mirror the depth of the downturn makes sense, and is borne out by the last seven US recessions. Should this happen, central banks would be forced to raise interest rates far quicker than is generally expected. This happened in 1994 and caused a big correction in government bond markets and a minor wobble in the stock market. A probability of 25%.

 

3. The 1976 scenario:

With concerns over governments defaulting on their national debts, will countries like Greece, Spain, Italy and God forbid, the UK, follow in the wake of Iceland and (almost) Dubai? Greece may well be bailed out by Germany and the EU, but Britain’s biggest problem is that a large part of our debt is owned by foreign investors. If they started to question our commitment to reducing the deficit or demanded a higher interest rate for investing in UK gilts, it would mean higher gilt yields and more costly borrowing.

 

The spectre of 1976 raises its head. Without being alarmist, there is already evidence that foreign investors have been reducing their holdings in UK gilts. They seem to be selling their gilts to the Bank of England, which is buying them under its quantitative easing programme. Interestingly, the cost of insuring against the UK Government defaulting on its debt (something that has never happened before, although it did restructure terms in the 1930s) has risen from 0.44% in October to 0.85% today.

To put it in context, Italy is 1% and Greece is 2.8%. But Norway is only 0.17%. While higher gilt yields seem highly likely next year the probability of this happening in 2010 remains signficant, but low, I’d put it at 10%.

 

So there you have it. Three scenarios with one common theme -- rising gilt yields. What happens if gilt yields fall as they did in 2008? Don’t get me started, as then we will all be worrying about deflation and the Great Depression II. I stress that the probability of that for the next year is very low. Here’s to a prosperous 2010 and fingers crossed it’s scenario 1.

 

Callum D’Ath is senior divisional director at Brewin Dolphin, Edinburgh. He is writing in a personal capacity and his views do not reflect those of his colleagues at Brewin Dolphin