Two major paradoxes in 2011

This should resemble the situation we had in 2005, with one notable difference, the extreme monetisation of the dollar, and one point in common, a buoyant equity market. And therein lies the first major paradox: government bonds are currently the most expensive asset and, at the same time, one of the most risky.

The soft-landing scenario is backed by a tangible weakening of world growth since Q2 2010. However, even if the economy can count less on public spending or corporate restocking in 2011, it will still benefit from the US Federal Reserve's second wave of monetisation (QE 2) and a slow but gradual uptick in private-sector demand, in terms of both consumer and capital spending.

To date, and despite the scale of such schemes, the various bouts of quantitative easing have not produced the expected relief, specifically in terms of employment and inflation, as the monetary base has remained flat and stocked in the form of bank reserves. We have, however, noted a salutary process of US household deleveraging, and this is likely to continue over the next few years on account of a higher rate of savings and a lightening of the debt load. This brings us to our second big paradox: US retail sales have been holding up very well since the start of 2010, probably due to the "wealth effect" associated with such monetisation. Based on this paradox, signs of a recovery in private-sector demand for credit have been emerging in recent weeks. We expect this to continue in 2011, underpinning our scenario of a soft landing.

The reason why this monetisation currently seems quite groundless, in terms of both inflation and interest rates, is the huge surplus capacity that remains in the US economy. For the time being, this is being used to print off dollars without any direct impact on either the consumer price index or real investment. This surplus capacity can be reabsorbed only very gradually, to ensure that the monetisation does not generate inflationary tensions within the next 12 months at least. The critical issue of having to withdraw such liquidity will thus only arise in 2012, with all the risks that this entails for the bond market and others.

For the time being, and in conjunction with the weak dollar at present, this monetary easing should only produce a reflation of assets, financial as well as real, thereby fuelling a wealth effect to help buoy the US economy. We can thus rule out a deflationary scenario in the US.

In emerging markets, an injection of liquidity is already causing major inflationary tensions, as evidenced by rising commodity prices, particularly in the agricultural sector. The affected zones, whether in China or elsewhere, have already embarked on substantial rounds of monetary tightening or measures to curb capital flows, which, if too extreme, could indirectly jeopardise our scenario of a gradual recovery in the developed world.

In Europe, on the other hand, the budgetary austerity that has become necessary in several eurozone countries and the ECB's withdrawal from certain monetary support programmes will favour an environment of "noflation". Switzerland will hardly be spared in such a case, given that the European Union is one of its main trading partners.

Overall, a situation of reflation in the US, "noflation" in Europe and inflation in emerging markets should work in favour of the more risky assets, particularly on equity markets, which are currently enjoying low multiples and attractive earnings prospects. Certain sectors, such as industrials, consumer cyclicals or agriculture, should benefit more generally from a soft landing, coupled with inflation in the emerging markets only.

Let us now return to our first paradox, mentioned in the introduction. For the first time in years, sovereign debt in developed countries appears to be the highest-risk asset class, despite the fact that interest rates are at historic lows. In contrast, equities offer a much higher combined return, in terms of earnings per share and dividends. The risk premium thus provides a compelling argument in favour of equities, especially with the risk differential becoming less conspicuous.

The issue of poor yields on public debt remains a structural problem. In buying up US Treasuries, the Federal Reserve has provided temporary respite only, modifying market mechanisms. Investors will obviously be hoping that the return to more normal interest rates is as slow and as orderly as possible, but this is by no means guaranteed. Such an exceptional situation will certainly be a source of serious concern to institutional investors, who traditionally invest widely in government paper. The alternative is to consider investing more in corporate bonds, investment grade or high-yield. Gold remains a recommended asset class: against a backdrop of monetisation and zero interest rates, gold is no longer just a commodity but actually the world's strongest currency.

In summary, 2011 should be something of a tough year, but one in which a well diversified portfolio can still make interesting returns, as was the case in 2005.