This year has shown why economics is known as the dismal science; with output falling, unemployment rising and a stack of problems for the future building up, times have never been so good for the doom-mongerers. 2009 has also proved to be a good year for investors; global equities are up some 30% year to date and over 60% from the low point, thereby recovering nearly half the fall since 2007. Corporate bonds, both investment grade and high yield, have performed well and, despite the dire warnings, returns from government bonds have been positive. Stock markets climb the wall of worry, and there are plenty of those at present. So much so that there is a danger that an excessive focus on the risks will lead investors to ignore the positives and so miss out on the potential returns which are there to be made over 2010 and beyond. These positives include the following.

1 On a prospective p/e ratio of below 14 times 2010 earnings, well below fair value of around 16, global equities remain very good value.

2 Earnings forecasts continue to be upgraded with over 60% of estimate changes positive. Analysts have responded cautiously to third quarter earnings which were well ahead

of expectations, so significant upgrades of the next few quarters’ earnings are almost inevitable. Initial estimates already pencil in mid teens earnings growth for 2011.

3 Corporate profitability has withstood a severe economic downturn well, largely as a result of strong productivity growth. Not only have costs been cut but there are significant pay-offs coming through from past investment, particularly technology related. The US productivity growth in this recession has been by far the best for 50 years. There is a danger that an excessive focus on the risks will lead investors to ignore the positives.

4 Economic growth in 2010 and subsequent years in developed economies is likely to be modest, but that should make the expansion phase long and durable. If it is based on investment rather than credit expansion or government spending, the result should be a more stable global economy and, possibly, an increase in the trend rate of growth.

5 The collapse of communism 20 years ago sparked political, social and economic change throughout what was then known as the third world. The consequence is strong economic growth and sharply rising living standards in what are now known as the emerging economies. This process has much further to go. Concern about the relatively few failures and dysfunctional states should not detract from the success of the many.

6 The fiscal challenge facing the developed economies in financing and reducing huge budget deficits is severe, but the experience of Canada and Sweden shows that it is not insoluble, and the economic and social cost may be surprisingly easy to bear. Moreover, public opinion is behind such retrenchment.

7 Bond investors do not require immediate and drastic action; if presented with a coherent plan over several years, they are likely to be willing to finance continuing deficits at modest interest rates. Spreads between corporate bonds and government bonds remain generous, particularly since the default rate appears to have peaked.

8 Interest rates are likely to rise in 2010 but this is already reflected in market interest rates. Well over 3% can be earned on 3 month notice deposits in the UK and nearly all

new fixed mortgages are charging an APR of above 4% already. A rise in interest rates will be an indicator of a return to normality, and therefore positive. There are significant further returns to be made in 2010 and, potentially, for several years thereafter.

9 The scale of quantitative easing in the developed economies has been huge but it has only counteracted the contraction in bank lending, and so threatens little inflation for now. Productivity growth and high output gaps promise continued low inflation while the withdrawal of liquidity in due course will be feasible if governments gain the confidence of bond investors in their fiscal policies. Runaway inflation as a result of printing money is far from inevitable.

10 Oil supplies are finite but reserve estimates for natural gas have been rising strongly. High energy prices have encouraged greater efficiency and the nuclear industry around the world is undergoing a renaissance, reducing the pressure on fossil fuels. High base metal prices are leading to investment in mine expansion and encouraging more efficient usage. As genetically modified crops spread around the world, crop yields will continue to rise while the faddish diversion of grain to produce bio-fuels is on the wane. In short, higher commodity prices are restraining consumption, increasing output and encouraging increased productivity. Cost push inflation and mass starvation are not in prospect.

11 Investors are focused on the uncertainties and reluctant to take risks. Flows into equities from both retail and professional investors are low and the slightest wobble in markets sends investors running for cover. Investors are more worried about the downside than excited by the upside and euphoria about the gains this year is notably absent. Poor sentiment is a classic indicator that the gains will continue.

We at Admiral believe there are significant further returns to be made in 2010 and, potentially, for several years thereafter.

Peter Waller – Investment Director