THE year began with financial markets in good spirits.

Data from employment and consumption surveys has justified added confidence that America is shaking off her lethargy even as growth in China and the emerging markets remains respectable in the face of tightening monetary policy postures.

In spite of this upbeat mood, the month of January finished with equities little changed.

The positive momentum has been checked by political developments in Tunisia and Egypt reminding us on the one hand of the ever-present risks when the fragile status quo of the Middle East is threatened and on the other hand, more directly and immediately, that the events have pushed up energy prices.

This, when taken together with a surge in food prices driven by unusual weather patterns (most notably in the grain producing areas of Australia) has turned investors’ attention back to the dangers of inflation.

We continue to hold an optimistic view on prospects for 2011.

Unless politics in the Middle East set off a chain reaction, pushing the oil price upwards to an extent that it “taxes” consumers and corporations back into a defensive mind-set, good economic growth (over 4%) is likely for the world in 2011 and 2012.

Furthermore, the balance between developed and developing regions is more healthy than at any stage in the past three years.

The corporate sector is in very good shape and consumers in developed economies have already substantially changed their ways to attune with more modest expectations.

In short, having confronted systemic threats of financial “life or death” in 2008, 2009 and in 2010, most of the challenges in 2011 look likely to be more conventional in nature, being those of dealing with a maturing cycle.

What are the key challenges? Most obviously, the embers of the sovereign debt fires remain hot and whilst investors appear to accept that Portugal may follow Ireland in requiring support, Spain would be a problem of a different magnitude.

Aside from this, investors will face a new challenge when attention begins to focus upon the timing and speed of the removal of currently extant “extraordinary” stimulus in the West, but particularly in America.

At such a time, the maxim of “Don’t Fight the Fed” that has served the brave well over the past 18 months could apply again, except in reverse.

An additional challenge will be dealing with slower earnings growth globally.

Consensus forecasts another year of double digit gains in corporate earnings for the key regions – the UK, the USA, Europe and emerging markets.

However, the era of “positive surprises” is probably over as elevated margins will come under pressure from rising commodity prices and the lower efficiency of incremental capacity additions.

To our mind, Europe is muddling its way to a solution whilst the latter two of the above challenges are “high class” problems and as such probably not serious issues until 2012 comes into focus in the second half of 2011.

Earnings are still expected to grow and historically the first move upwards in policy rates has been taken as confirmation of a recovery, rather than as a harbinger of its imminent curtailment.