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4 January 2010

2010 Crystal Ball

Last month we highlighted some of our ‘big picture’ successes and not so great successes over the
past 18 months although there were very few of the latter. Before looking into our crystal ball as regards
2010 and possibly beyond, it is worth recalling our calls:

• The recession, particularly for the UK, would be considerably deeper and last longer than most
commentators and central bankers thought – this is indeed the case;

• UK interest rates would plunge close to zero, if not zero – Bank of England has dropped and
held the rate to 0.5% (an historic low) and would have fallen lower had it not decided to print
money to inject credit into the system;

• Inflation would reverse and possibly herald a prolonged period of deflation – Quantitative
Easing by injecting inflationary levels of money into the financial system may have arrested this
threat but only time will tell;

• Worst of the recession would probably have occurred during the first half of 2009 – the worst of
the recessionary decline occurred in the first half;

• Having called the turn in the oil price in our note of 7 July 2008, the oil price collapsed as the
global bite and speculative financial trading positions were unwound;

• Oil price would stabilise at around US$70 – US$90 bbl because of the ending of the globally
synchronised recession and its gradual recovery together with OPEC’s active management of
market expectations, both demand and financial;

• The UK equity bear market would end sometime around March/April 2009 – the following chart
clearly demonstrates the case; and

o FTSE100 following a period of consolidation would then outperform during the second
half

§ FTSE100 +18.4% (2 January 2009 – 25 December 2009);

o Small/Mid Caps would perform better than their bigger brothers

§ FTSE AIM All Share +59.7% (2 January 2009 – 25 December 2009)

o Despite significant refinancing across the entire equity markets.

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Chart: FTSE100 & FTSE AIM All Share 2/1/2009 – 25/12/2009

6000 700

650
5500

600

FTSE AIM All Share

5000
550
FTSE100

4500 500

450
4000

400

3500
350

3000 300
09

09

09

09
/09
09

9
/09

/09

2/0
/3/

/6/

/7/

/9/
/2/

7/5
1/1

/10

3/1
26

18

30

10
12

22
FTSE100 FTSE AIM All Share

Source: Thomson Reuters

Our big picture calls, most of which were made during the first half of 2008, were bold and cynics with
20/20 hindsight might say obvious but how many economists, strategists, credit analysts, financial
commentators, Central Bankers at the time actually made similar calls – very, very few indeed!

Moreover, we were, and remain, consistently scathing of Gordon Brown’s gross economic
mismanagement of the UK economy, both as Chancellor and Prime Minister, and in a note published
on 7 July 2008 summed up our view as follows ’… Sadly for King Canute (aka Gordon Brown), the tide
will hit our shores harder than most other economies. Gordon’s inspired policy of escalating taxes for in
excess of a decade only to be squandered on saving the World and UK’s structurally flawed state
bodies have drained our reserves. … If Gordon is relying upon the consumer (that’s right you and me),
he is going to be very disappointed and is yet another mistake to add to his growing list since his first
day as Chancellor. … The poor consumer’s disposable income has been progressively absorbed by
continually rising taxes, both Central and Local Government, escalating energy, transport and food
costs while, more recently, confidence has been demolished by the property market’s recession. The
consumer slowdown is manifesting itself now in the high street where there have been two high profile
profit warnings, Marks & Spencer and John Lewis; more will follow. …’

Indeed, the consumer is, and remains, a net repayer of credit; a trend that is unlikely to change anytime
soon.

So what are our big picture forecasts for 2010?

Firstly, we would summarise 2010 as a ‘Year of 2 Halves’ because of the election. The first half will be
dominated by pre-election posturing and the second half by the economic reality because whichever
party assumes power will have to tear up Alasdair Darling’s recent pre-Budget report and his March

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Budget and establish an economic framework that properly addresses the UK’s burgeoning debt
mountain.

We have tried to categorise our comments in light of the above expectation, so here goes:

• 2010 the Election Year

o 1st half will be dominated by political posturing and spurious rumours of a snap election
that will create significant market volatility

§ A snap election is also unlikely because Gordon Brown is incapable of making

decisions so an election will only occur once the sands of time for this
Administration finally run out on Thursday 3 June 2010.

o Markets will become increasingly obsessed as to the possible outcome

§ Conservative landslide – big ask!

§ Hung Parliament – possible and would be bad for markets because there
would be a hamstrung Administration;

§ Small working majority

• Labour – more of the same maladministration, the probable loss of the

UK’s AAA bond rating and bad for markets; and

• Conservative – tear up the March Budget and issue an Emergency

Budget to address the UK’s distressed economy and preserve the UK’s
AAA credit rating by establishing a credible plan to address the budget
deficit; and take the inevitable but painful decisions to shrink the public
sector that, generally, should be good for markets.

• Economy

o UK should have crawled out of recession during Q4 2009 or Q1 2010 but the recovery
will be anaemic, even though starting from a statistically low base;

o Economic recovery will be constrained due to the persistent lack of readily available
credit, consumers repaying debt, reversal of ill-conceived, panic tax concessions (e.g.,
reduction in VAT), reduction in tax thresholds and newer taxes (broadband tax, higher
NI in 2011 and the spitefully, destructive ‘City’ bonus tax) will inexorably drain further
cash from businesses and consumers. In addition, transport and utility costs and
Council taxes will also move upwards adding to the progressive and relentless
reduction in discretionary spending capacity;

o Unemployment will continue to rise and post the election the rate of increase could
accelerate in both the public and private sectors;

o Quantitative Easing may have to end because of the present Government’s inability to
stem the rise in borrowing;

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o Consequently, interest rates will either remain at 0.5% or be reduced further to possibly
0.125% or lower in an attempt to provide some further stimulus to a weakening
economy following the implementation of a draconian post election Emergency Budget.

o Credit demand is likely to remain constrained as consumers continue to reduce their

indebtedness and the banks rebuild their balance sheets;

o Inflation will temporarily exceed the Bank of England’s target range due to the reversal
effects of earlier cuts in VAT and subsequent recovery in utility costs but the underlying
trend probably remains subdued;

o Sterling may weaken against both the US$ and € as the US and the leading European
(Germany, France and Italy) economic recoveries build momentum; and

o UK’s AAA credit rating will only be maintained if a credible and manageable budget
deficit programme can be established by whichever Administration is elected in mid-
2010. Since this is likely to be a long term programme, the next Chancellor of the
Exchequer will be committing several future Government’s to specific and strict targets.

• Gold price may hold onto its 2009 highs through most of 2010. Indeed, the gold price may push
to slightly higher levels before its upward momentum finally peters out. Thereafter, there is
likely to be a period of plateauing before the price starts to weaken into 2011 as alternative
investment demand rapidly subsides as the global economic recovery builds momentum and
further evidence emerges of the strengthening of the global financial system.

• Oil price (Brent) is likely to remain within OPEC’s managed range of US$70 – US$90 bbl as
supply and demand are broadly maintained; and

• Equity Markets

o Overall equity markets, as measured by indices, are looking tired after the 2009 run
and by the end of 2010 may be broadly similar level to their January open.

o The first half of 2010 will be heavily influenced by election fever creating substantial
volatility. But the underlying trend is likely to be down because the refinancing of UK
corporate balance sheets has not finished due to credit markets remaining constricted.
Indeed credit may get tighter in 2010 due to rollover effects of Gordon Brown’s long
term economic mismanagement, which creates further credit defaults that in turn
weaken already drained bank balance sheets;

o The second half will then respond to the economic reality that the new Administration’s
Emergency Budget will establish, which may create a period of sector rotation or
portfolio repositioning;

o Nevertheless, M&A activity should steadily increase as the year progresses thereby
providing much needed support to the indices. Investor preference will be for cash
offers rather than paper/cash or pure paper offers. Moreover, M&A activity will be led
by overseas rather than UK companies;

o IPO market will remain very subdued until corporate balance sheets have been
successfully refinanced. Even then, investment appetite is likely only to be for the best

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and most attractively priced issues; the failed Gartmore IPO clearly demonstrates the
point.

Therefore, pulling all of our thoughts together would suggest the following Sectoral weighting:

Under Weight Over Weight

Automobiles & Parts, Banks, Electronics & Electrical
Equipment, Engineering & Machinery, Food & Drug
Stores, Food Producers, Health, Information
Technology & Hardware, Insurance, Leisure &
Hotels, Life Assurance, Media & Entertainment,
Pharmaceutical & Biotechnology, Support Services,
Transport, Utilities.
Aerospace & Defence, Beverages, Chemicals,
Construction & Building Materials, General
Retail, Household Goods, Mining, Oil & Gas,
Personal Care & Household Products, Software
Services, Speciality & Other Finance,
Telecommunications

Source: Intellisys Trading & Value Indicator, 4 January 2010

Nevertheless, successful equity investing is not just about picking the right sector exposures or
weighting but stock selection and that is up to each investor because only they know their specific
investment criteria – we would recommend our Trading & Value Indicator (published daily before official
trading starts) as a tool to assist in that stock selection process.

Philip Morrish

Philip.morrish@intellisys.uk.com

T: +44 20 3239 8994

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