Three Scenarios for 2011

Predictions at this time of year often give the seductive impression of accuracy.

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Analysts put the standard inputs into their model and disgorge a prediction for indices 12 months hence. They do not even put a confidence interval around those predictions, let alone acknowledge that alternative scenarios exist.

The crisis revealed that such methods lead to overconfidence. It is better to acknowledge uncertainty. It makes more sense to look at likely scenarios and the rough probabilities that they will occur.

Here, then, are three plausible scenarios for 2011.

The Crab: markets carry on as they did in 2010, undulating in response to the latest economic news. Exceptional stimulus from governments and resilient demand from China allows a continued slow and messy recovery from the crisis; the weight of continuing corporate and household deleveraging, the weak US housing market plus the threat of tighter monetary policy if sustainable growth appears on the horizon puts a lid on gains.

Chances: about 70 per cent.

Disaster: Bond markets refuse to finance the US deficit and drive an existential crisis in the eurozone. With government credit ratings no longer effective in shoring up the creditworthiness of US and European banks, asset prices plumb depths not seen in 2008-09. China lands hard.

Chances: maybe as high as 20 per cent.

Lift-off: US consumers start spending, China moves on serenely and investors get into the market. As companies spend their cash, equities enjoy a big rally. Everyone is happy except bond investors.

Chances: about 10 per cent.

The critical variables are the US bond market and the Chinese economy. If both stay out of trouble, disaster is off the table. Rising US deal volumes and house prices might signal a true lift-off.

Without these, expect the crab – which means another year leaping between asset classes in response to new information. Markets stay correlated, there is money for those who time the swings in sentiment, and nobody gets hurt too badly.