The worst recession in memory is now behind us, as is one of the strongest market rebounds we’ve ever experienced. So, what’s ahead for 2010?

It’s no surprise that the fortunes of the world’s largest economy, the U.S., will determine much of that. But the U.S. economy is a major uncertainty this year. Will it stagnate? Will it have moderate growth? Will it have surprisingly stronger growth?

There are economists and global money managers in all three camps, so you’ll have to consider the evidence carefully before deciding on how you should position your clients.

If the stagnation scenario unfolds, then cash, maybe some government bonds, commodities (especially gold) and emerging-markets equities will be the best places in which to be invested. And any exposure to the U.S. dollar should be hedged because the greenback would continue to decline in this scenario.

In the moderate growth scenario, corporate bonds and broad geographical diversification in equities, with a mix of cyclical and defensive sectors, would work.

And if U.S. economic growth surprises on the upside, then the recipe for success would be a portfolio underweighted in bonds and overweighted in U.S. equities, particularly consumer discretionary, industrials and financials.

Although the safest bet is the stagnation asset mix, clients won’t be happy if they miss out on strong equities gains. So, you need to make sure they understand why stagnation is a real possibility and how much they could lose if that were to happen. Meanwhile, assuming relatively strong U.S. growth is the riskiest way to go, you could reduce the risk by suggesting more defensive equities than normal for the recovery period, as well as currency-hedged investments.

Thus, you could have an asset mix that would do well as long as the U.S. keeps growing. It would not do well in the stagnation scenario, but the currency hedging and the defensive equities would somewhat lower the downside risk, at least, should the U.S. growth engine stall. Confining U.S. equities held in client portfolios to multinationals whose sales are truly global and overweighting resources, which have excellent long-term prospects, would further lower the risk.

Regardless of the scenario that occurs in the U.S., there’s one factor that needs to be taken into consideration: you will need to be careful which stocks your clients hold and make sure they are quality companies, as money managers say investors will punish stocks that don’t meet earnings expectations.

In addition to the U.S. economy, there are other uncertainties this year. Will China be able to withdraw monetary and fiscal stimulus without halting economic growth too much? Will oil prices stay high? Will base metals climb further? Will the U.S. dollar drop or will it rally?

China has recovered quickly from the global recession, thanks to a US$586-billion spending program, huge growth in domestic money supply and massive government-ordered lending by the banks. If left unchecked, all these measures will lead to rampant inflation. But if the central bank pulls back too fast, the economy could falter. Getting the right timing and degree of tightening is further complicated by the concern on the part of the Chinese authorities about social unrest if the economy slows too much.

As for oil prices, they have bounced back faster than expected, spurred by the quick recovery in China and the other Asian emerging economies. But speculators also have likely played a role. The question is: how much? John Arnold, portfolio manager with AGF International Advisors Co. Ltd. in Dublin, suggests oil prices could fall to US$35 a barrel, while others believe they will keep climbing. (See story on page B6.)

Base metals prices also have shot back up more than expected. In this case, stockpiling by China was a factor. With its current high inventories, China will probably not need to keep buying at the same rate, even if it keeps growing at a strong pace; should China’s economy falter, prices of base metals would probably pull back.

The US$ would fall against most currencies with the stagnation scenario but rally if U.S. growth surprises on the upside. Still, that doesn’t necessarily include the loonie. As Canada is a major resources exporter, the Canadian dollar is viewed as a resources currency and, as a result, goes up and down with resource prices. (See story on page B4.)

@page_break@Also worthy of consideration is the risk of inflation and asset bubbles in emerging countries, particularly in Asia. “If there’s a bubble, it could be disastrous if it bursts,” says Stéphane Marion, chief economist and strategist with National Bank Financial Ltd. in Montreal.

Inflation should not materialize in the industrialized world this year because there’s too much spare production capacity for upward price pressure to materialize, and unemployment is too high to generate big wage demands. That said, inflation is a threat over the medium term, given the huge increases in the money supply in the U.S. and elsewhere. Furthermore, governments may decide to encourage inflation to make it easier to pay back the debts they’ve accumulated due to their huge fiscal stimulus packages.

The biggest risk on the horizon is U.S. stagflation, but there could also be a double dip in the global economy — falling back into recession. This could be caused by U.S. commercial real estate defaults. However, most of these loans are held by small U.S. banks and haven’t been securitized and purchased by the big U.S. and European investment houses and banks. Thus, a collapse of many of these smaller banks would be very negative for U.S. consumer confidence but shouldn’t threaten the financial system.

In general, money managers believe the credit crisis is over, but they admit its impacts will be felt for some time. Specifically, there’s concern U.S. banks may continue to be hesitant about lending. So far, those banks have used the government stimulus money mainly to bolster their balance sheets.

The willingness of banks to lend is also an issue in Europe, including Britain. Without increased lending, small and medium-sized businesses that cannot access capital markets will have difficulty restocking and expanding — and it’s these companies that tend to be the engines of economic growth.

There is also concern about sovereign risk — particularly for countries such as Greece, but also more generally. There are a huge number of government bonds out there. If the markets become nervous, rates could be bid upward even if central banks aren’t raising their official rates, says Peter O’Reilly, global money manager with I.G. Investment Management Ltd. in Dublin.

Here’s a look at the three possible economic scenarios:

> U.S. Stagnation. The money managers who say this is the likely scenario include Jean-Guy Desjardins, president of Montreal-based Fiera YMG Capital Inc.; Ross Healy, president of Strategic Analysis Corp. in Toronto; and Nandu Narayanan, chief investment officer with Trident Investment Management LLC in New York and manager of several CI Investments Inc. funds.

Healy considers the U.S. to be in a second-order insolvency, in which the economy cannot generate enough income for the government to pay the interest on its debts, resulting in continued increases to that debt. He says stagnation will go on until “huge and extraordinary measures” are taken to restore U.S. fiscal health. He isn’t sure about Europe’s prospects, given its structural issues, but believes China and India can continue growing.

Narayanan doesn’t see much growth in consumer spending in the U.S. for the next few years, as consumers pay down debt; thus, he thinks another dip into recession is most likely. He also suggests Japan is in just as bad a shape, but thinks the rest of the world, particularly the emerging world, can keep growing. But, like Healy, he’s cautious on Europe.

Desjardins thinks global growth rates will be low for a very long period because there’s been no change in the global imbalances, with some countries continuing to rack up huge trade surpluses while others have massive deficits. What’s needed is for China to appreciate its currency, but that’s not something that it wants to do.

Given this doom and gloom, Healy thinks it’s too late to get into the bond market because inves-tors aren’t being paid enough for the risk. His clients are mainly in cash, and he would urge them to go to cash entirely if the S&P 500 composite index gains another 8%-10%. But once the market corrects, he would move them back into equities to take advantage of low prices.

Narayanan is invested 70% in fixed-income and 30% in equities, focused on companies with hard assets such as resources. He also likes some high-quality consumer-staple multinationals.

Desjardins is unenthusiastic about both equities and traditional fixed-income. He recommends alternative fixed-income, such as lower-rated investment-grade bonds, preferred shares and certain income trusts. “We can put together portfolios with returns of 7%-8% a year without risk exposure that’s much greater than in traditional bond portfolios.”

Desjardins adds that there are interesting opportunities in the regulated public sector, pointing to the infrastructure pool that can generate 8%-10% a year.

> Moderate U.S. Growth. Two money managers in this camp are Andy MacLean, director of private-client strategy with Richardson GMP Ltd. in Toronto; and Norman Raschkowan, chief investment officer with Mackenzie Financial Corp. in Toronto.

Raschkowan is expecting 2.5% growth in the U.S. and 2%-2.5% in Europe this year, followed by a number of years of relatively slow growth. Economies will be weighed down by the higher cost of credit and the higher taxes and/or lower government spending needed to pay down their debt.

MacLean also expects moderate growth in the U.S. and Europe, and he thinks that Japan — which is very dependent on exports, especially to the industrialized world — is likely to grow by just 1%-2% for several years.

Both MacLean and Raschkowan suggest that emerging markets should continue to have strong growth, as increased domestic demand helps offset slower export growth. Raschkowan notes that emerging markets’ exports haven’t been hit as hard as those from the industrialized world because North Americans have switched to cheaper goods, many of which come from the emerging world.

Against this backdrop, Rasch-kowan believes earnings will disappoint in the industrialized world. Although expectations are for a 25% increase in the U.S. and Europe, he thinks 12%-15% is more likely. He does, however, think expectations for a rise of almost 30% in emerging markets is reasonable.

That said, Raschkowan notes the riskiness of emerging markets and recommends they account for no more than 33% of equities held in a client’s portfolio, preferably 10%-15%. He finds U.S. multinationals that export to be attractive and says industrials will do better than consumer stocks. He also believes corporate bonds are attractive, noting that you can get almost 5% yield on a high-quality corporate bond vs only 3.5% for a 20-year Government of Canada bond.

MacLean agrees about strong earnings growth in emerging markets, but he expects better gains in the U.S. than Europe or Japan.

MacLean recommends pro-cyclical equities, such as resources, technology, some consumer discretionary and certain financials. When interest rates start rising, he suggests becoming more defensive by adding telecommunications and consumer staples.

> Robust U.S. Growth. Six money managers polled say U.S. growth will surprise on the upside, but only O’Reilly expects the kind of bounce-back that could result in growth as high as 4%-6%, which is more typical of recovery periods.

Marion and Lloyd Atkinson, an independent financial and economic consultant in Toronto, assume growth of around 3.5%.

Arnold, Charles Burbeck, an inde-pendent global money manager in London, and Bill Sterling, chief investment officer with Trilogy Advisors LLC in New York, which manages a number of CI Investments funds, are assuming growth will be in the 3% range.

Although none of these money managers deny the longer-term issues, they argue that the U.S. is the most flexible and resilient economy and, thus, is likely to recover more quickly than many expect. They also feel that there’s bound to be some recovery in housing and auto sales from their current depressed levels and that inventories are so low that any pickup in growth will have to be accompanied by more production.

O’Reilly also says that only about a third of the huge fiscal stimulus, which is estimated at 7% of gross domestic product, came through last year. Others agree that there will still be an impact from these programs in 2010, although Atkinson says that much of the stimulus at the federal level is being offset by cutbacks on the part of state and local governments that are required to balance their budgets.

Arnold thinks the U.S. personal savings rate will go down to 5% from 7%. And as that’s still well above the normal 3% rate, it will allow for both debt repayment and more consumer spending.

All six money managers are reducing their fixed-income exposure and increasing their equities holdings. Most are overweighting the U.S.; all are overweighting emerging markets; and most are underweighting Europe and Japan.

Arnold is the maverick, with 53% in Europe and only 12% in North America. His enthusiasm about European equities is a long-time stance based on valuations. He points out that the average price/earnings multiple in Europe is 15, vs 21 in the U.S., 19 in Asia (minus Japan) and 32 in Japan.

O’Reilly says he’s starting to find quality European companies to invest in, but considers U.S. equities a better bet. He is the only money manager increasing his exposure to Japan, as he believes exporters in that country will benefit from strong global growth. That said, he is hedging his exposure to the yen.

The money managers point to poor demographics in Europe, marked by aging populations and relatively weak consumer spending growth, and even more so in Japan. There’s also the high value of the euro and yen, which hinders their exporters. Europe also has structural issues, such as inflexible labour markets and uniform monetary policy that can lead to monetary stances inappropriate for some countries. Meanwhile, Japan is the only major country not to have implemented a big fiscal stimulus package.

The outlook for the following sectors is also divided:

> Resources. O’Reilly is reducing his resources weighting and Sterling is roughly neutral. Neither foresees upward pressure on oil prices or base metals.

Atkinson doesn’t foresee higher oil prices, but thinks base metals prices will climb. Burbeck is quite positive on resources, generally, while Narayanan is still invested in them and MacLean recommends them. Marion is overweighted in energy, saying that “valuations aren’t overstretched.” And despite Arnold’s expectation of a drop in oil prices to US$35, he thinks there’s “still innate value in the stocks, which haven’t risen that much.”

> Financials. Arnold remains overweighted in the sector and O’Reilly and Sterling are increasing their exposure; MacLean likes certain financials, noting that banks usually do best early in a recovery, with insurance kicking in later. Atkinson is underweighted in this sector; Burbeck isn’t sure about the sector.

Arnold has two-thirds of assets invested in banks and one-third in insurers. He favours retail banks.

O’Reilly believes U.S. banks are closer to rehabilitation than most people think and suspects they will be able to grow out of the commercial real estate problems. He’s mixed on European banks and has taken small positions in non-Japanese Asian banks, which “are in pretty good shape.”

Sterling is also cautious on Euro–pean financials. He feels that many of them have not made the right moves and may have swept troubles under the accounting rug, so they may have to raise more capital. He adds that there may still be issues concerning non-performing loans.

Atkinson is concerned about the life insurers; he suspects they have many investments on their balance sheets, including commercial real estate, that will have to be written down.

Burbeck says that financials already had a good run last year and notes the uncertainties about their future regulatory environment. But he wouldn’t write them off.

> Consumer And Health Care. O’Reilly is increasing his exposure to U.S. consumer discretionary and staples. Marion is still overweighted in consumer discretionary, pointing to pent-up demand after 22 months of recession. Sterling is overweighted in discretionary but underweighted in staples.

Arnold is reducing his consumer-sector exposure, as he feels valuations are getting ahead of the economy. However, he is still quite heavy in health care, particularly vaccine producers.

Burbeck thinks it’s better to focus on sectors exposed to capital investments rather than consumer-driven stocks, although he says that there is case for some consumer companies.

> Industrials And Technology.
Burbeck expects technology companies, which “are in very good financial shape” to continue to do well. Marion and Sterling are overweighted in technology, and Maclean also likes the sector. IE