The latest report by Barclays Wealth specialists

Fears of a Great Depression have receded, helping equity markets to rally since their early March lows.

The focus has shifted to the shape and longevity of the recovery.

We expect a ‘deformed’ V-shaped business cycle, in which the up-leg has a shallower slope than the down-leg.

• Our central forecast is for a sluggish recovery (60% probability).  However, there could be a recovery with real momentum (20 probability), or a slide back towards the abyss of prolonged depression (20%).

• In the past few months, it has been clear that countries which have experienced the biggest policy shifts have enjoyed the fastest and largest turnaround in their fortunes.

• Consequently, emerging markets (especially in Asia) are generally more advanced in the economic cycle than the 'advanced' economies. Among the developed economies, the US will lead the way in recovery.

• Clients are growing worried that inflation will soon rise strongly. We judge that these inflation fears are overdone, largely because governments will find it difficult to gain control of the money printing presses. Overcapacity and unemployment will also keep

the lid on wages growth.

Michael Dicks, Head of Research at Barclays Wealth, said 'This sort of macroeconomic scenario is a rather more benign one than that we experienced last year.  But it may not be one in which riskier asset classes – such as credit or equities – soar.

'For the truth is that the recent rally has removed much of the cheapness in these asset classes.'

'All in all, the summer looks to be a period of steady as she goes. Only in the autumn do we expect confidence in the recovery’s persistence to grow, and riskier asset classes to really outperform again'.

Asset classes

• Short-term interest rates will stay low for some time. Policymakers will not start their exit strategies until the second half of 2010, at least in terms of rate hikes.

• Bond yields will trend higher. But quantitative easing will help limit the process, as will the fact that the recovery will not be robust. So, we do not expect the bond yield back-up to be an abrupt one.

•  Credit spreads will resume narrowing again – but perhaps after taking a bit of a holiday. After all, we are at that stage of the cycle when defaults will rise markedly. And spreads are back to pre-Lehman levels.

• Equity markets will rise, but after a bit of a pause. Here, profits performance may well turn out to be as important as the macro picture in helping to generate another leg to the rally.

• Commodity prices will rise, but with little vigour. The reacceleration of activity in China and other emerging markets could well push some commodity prices higher than is warranted.

• Real estate will be patchy over the summer. Commercial property markets have managed to stage a strong rally during the second quarter of this year, and we would not be surprised if they make further headway. But in some markets – such as the US – the recent move up seems almost too good to be true: expect a little indigestion.

•  In FX markets, 'riskier' currencies should rally. The euro is likely to shed value, as it is still expensive, while sterling should appreciate a little. Asian currencies should also be beneficiaries of economic recovery.

Economic update: US

• The US economy should crawl out of recession during the summer, as improving business and consumer confidence highlight the fading of defensive behaviour.

• Moderate household consumption and fixed investment growth, however, are likely to sap the strength of the recovery. We continue to look for a modest 1% expansion in the economy next year.

• A large degree of economic slack should warrant further deceleration in core CPI readings. Driven by falling wages, core inflation could drop below 1% in 2010. 

Economic update: Euro area

• An exceptionally deep recession is underway in the euro area, with particularly sharp cuts in investment and in firms’ inventories, and a return to growth appears unlikely before the fourth quarter.

• The extreme weakness in output in Q1 is seemingly starting to abate, however, judging by the recovery in business sentiment on the one hand and some 'hard' short-term indicators on the other.

• Inflation will remain negative for a few months and, while rebounding, should stay well below the ECB’s target level next year due to rising spare capacity and unemployment. That should prevent rate hikes for some time.

Economic update: UK

• The near-term outlook for the UK economy has brightened markedly during the second quarter. Our long-held forecast for a return to positive growth by the end of the year is still on track.

• As a result, the risk of a long and protracted period of recession and deflation has eased considerably. Headline CPI inflation is likely to remain positive and increase before the end of the year, but not sharply.

• We doubt that policymakers will be quick to tighten policy, given the soft foundations of, and risks to, the recovery, and mounting spare capacity.

Economic update: Emerging Markets

• Emerging markets were not spared the brunt of the global slowdown, but signs of stabilisation, and a return to growth in some countries, have emerged, particularly in Asia.

• We continue to expect emerging economies in general to lead the recovery. Those countries where policymakers have worked hardest to boost demand, such as China, will be at the forefront.

• The monetary policy cycle is nearing its trough in many counties. Having fallen sharply, inflation is likely to turn up around the turn of the year, thanks mainly to the recovery in commodity prices.

The full report is available to download here.