Looking Ahead to 2011.

Well where to start with 2011? 
In reality, it is probably the worst time of the year to be discussing the market and economic recovery, as most market watchers probably retain too much good feeling as a result of the traditional New Year's celebrations.
I would liken it to the experience of supermarket shopping on an empty stomach which can make it all too easy for us to fall into the subtle sales techniques of supermarkets (the alluring aroma of fresh bread or roast chicken is a killer!).

However, from a media point of view it is traditional to review the coming year so, with that caveat aside: economic recovery; sovereign debt; and inflation concerns; remain at the forefront of any global discussion on 2011 but, of more immediate interest to the UK is: the impact of austerity measures (e.g VAT increase); inflation; and interest rates.

Austerity Measures.
The first quarter of the year is likely to be dominated by plenty of short term reaction to the VAT increase to 20%.

The reality of the situation is that, for the majority, the VAT changes will have little impact upon personal spending behaviours, in much the same way that changes to 15% and 17.5% had little effect, it may just cost more!

It is slightly farcical when a 2.5% increase is worried about in the face of perpetual sales of up to 50 and 75% reductions, or 4 years interest free credit, or where the advance in consumer electronics makes last month's must have item obsolete to the point where it can be purchased significantly cheaper, it just doesn't add up. 2.5% of what base price?
In many cases where there is choice and competition, we will just shop elsewhere. The pressure comes when the service is specialised, essential or legislated to the point where price increases can just be passed on such as in fuel prices or gas and electric.
Other measures, such as NI increases, could well be more significant to business as will be the impact of inflation and interest rate policy.

Inflation, Interest rates and Sterling.
Possibly more than any other developed economy, the UK is dependent upon cheap imports and consumer spending to support a huge number of people in employment and a cycle of money in the economy.

The key enabler to this in recent times has been a strong pound (which made imports cheaper), and cheap credit which gave people access to spending power they didn't have. 
When the recent bubble in oil prices prompted forecasts of $200 per barrel, and resources began their so called "super cycle", the strength of Sterling (at up to $2 to £1), took some of the sting out of these dollar denominated inflationary pressures.

As it is, with the strong possibility that the BoE is trying to inflate the UK out of its current woes, it also risks exposing us all to the full impact of international inflation by exacerbating the increasing costs of imported goods and resources through artificially low interest rates weakening sterling's position against other currencies. 
The national debt may only be paid down slowly but its relative value in, for example, 5 years time could be much diminished once the deteriorating effect of compound inflation is taken into account. This would also be the case relative to GDP if the recovery is strong enough.
It is arguable that, with this high stakes game of chicken, the BoE is dangerously close to losing control of inflation which could lead to a rapid series of interest rate increases if it needs to firefight its way back ahead of the curve. And, if the recovery isn't strong enough.....the potential overreaction could cause further damage to the UK economy.

What next then for 2011?
Well, the VAT increase has now been implemented. And, as ever, following the key Christmas trading period, retailers will be first up to report with their weather related woes and a shortened sale period (4th Jan VAT increase). 
So, expect the weaker retailers to drag down the sector with the risk that some will fail as competition and cost pressures do their damage throughout the year.
You also won't be able to escape hearing about the detrimental effect of the VAT increase (and other austerity measures), as the Alzheimer affected opposition party predictably criticise a response to a situation that they will have us believe that they had nothing to do with!

Smaller businesses will find it much more difficult though, as they are likely to be in the bracket of companies with little choice but to try to pass on cost increases making them less competitive. Such is the nature of competition, it will be those companies that can extract further cost efficiencies in their operations that will prosper, and maintain their profits.

In the past supermarkets have been good examples of organisations capable of achieving a balance of cost efficiencies whilst also being able to pass on certain costs in the sale of essentials.
Sectors and companies with international spread and/or dollar derived profits will also have some flexibility to manage their cost bases.
Commodities will continue to be on the right side of the exchange rate sum and their fates will be intertwined with China and continuing global recovery.

At some stage, interest rates will have to rise to combat inflation.

Despite these concerns, I still believe that the global economy will continue to recover. And, for a time, there will be opportunities to continue to develop a portfolio of recovering companies that will come through this and deliver share price recovery and consistent dividend growth. I have previously hinted at diversification and would like to have more sector diversification in my Value and Income portfolio. As ever, price and value is the deciding factor but I am thinking specifically of pharmaceuticals, supermarkets, telecoms and, at some stage, banking.

Alternatively, there will still be companies capable of growth but, in the continuing credit constrained conditions I will continue to focus on those recognisable household names (preferably with healthy cash positions) that are able to influence global trends and create new markets for their products.

Finally, with domestic inflation a concern (and interest rate policy), I am open to more overseas opportunities, particularly in the US, which I believe will drive global recovery and provide an additional benefit if the dollar strengthens. I won't exclude investment in Europe but deciding the direction and fate of the Euro and sovereign debt, is not as simple as flipping a coin! It is these last two factors that give me caution when considering the banking industry although those with exposure to growth markets could be attractive to my mind, such as Standard Chartered and HSBC.