Margareta Pagano: From rollercoaster to helter-skelter

Prepare for another year of living dangerously. If this year was a roller coaster in the financial markets, then next year threatens to be all downhill. Stock markets are forecast to fall sharply again, while sterling is set to take another battering as investors around the world take flight from the UK.

Economists are predicting the worst recession since the post-war downturn, after the latest figures from the Office for National Statistics showed the British economy had contracted by 0.6 per cent in the third quarter – the worst performance since the recession of the 1990s. And, even gloomier, the Centre for Economics and Business Research last week predicted the economy would shrink by 2.9 per cent in 2009 – the largest amount since 1946.

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Experts are now suggesting that the recession has much further to bite, with swathes of jobs still to go from retail banking, taking the total to well above 3 million over the year. Manufacturers are preparing for tougher times by taking a month off over the holiday break while at least 15 big-name retailers are said to be on the brink of insolvency. Thousands of jobs will be cut from our biggest high-street banks as they slash operations and recapitalise.

But UK plc faces an even greater peril. Guy Wolf of Oxburgh hedge fund is among the most pessimistic. He says markets fear that the UK, which now has a credit rating lower than McDonald's, could be the first major sovereign country to default on its debt: "There are genuine fears that the UK could implode because of the burden of debt. We are trapped in a deflationary spiral. Tax revenues are falling because of declining income from the City while spending is continuing to rise and the UK is bloated with debt."

Wolf predicts that Britain will suffer a period of deflation similar to Japan in the 1990s, which could last up to a decade. "There are only two ways to get out of such a trap: through inflation or growth. But tragically the Government's attempt to repair the excesses of cheap credit and huge leveraging will not lead to growth. We need to pay off our debt, not spend more."

Rather than pump-priming the economy with VAT cuts and higher taxes, Wolf says the Government should slash taxes, cut public spending to essentials and encourage households to pay off debt. It's this that leads him to forecast the UK stock markets could fall another 25 per cent over the next few months. "We have yet to see a proper capitulation – at the moment it's still the banking system which is overwhelmed. Now it's the turn of the real economy."

That's why sterling looks so fragile and why economists reckon the pound has another 25 per cent to fall against the dollar as investors continue to pull out of the UK and turn to the US, which is seen as a safer bet and able to recover quicker than the UK, or Western Europe. As Wolf says, if you had a $1m to invest, where would you put it? The US or the UK? It's a no-brainer.

And the Obama factor still has a bit further to play, says Geoff Wilkinson, economist at Mint Brokers. Financial markets should get a bit of a boost by the president's inauguration at the end of next month but then he expects another shake-out which could last until the summer. "We are getting to the point where the markets can visualise the bottom, but we are not there yet."

Then Wilkinson anticipates the US economy will start to recover. "With oil at $40 a barrel I expect the US machine to get going again," he says.

But it will be a long haul, particularly for the investment and hedge-fund industry, still undergoing a massive shake-out from the huge leverage built up during the past decade's bull market. Hundreds more hedge funds, and the feeder funds that have been so exposed by the $50bn Bernie Madoff scandal in the US, will go bust because of losses, and because so many of them failed to deliver. As Wolf says: "Too many hedge funds charged investors much too much, paid themselves ridiculous amounts and failed to deliver what they are designed to do – which is absolute returns."

Expect greater pressure from the regulators for more transparency. This can only be good for the industry which is likely to go back to how it was a decade ago – smaller, more nimble funds for fewer wealthy individuals.

However, this leaves the institutional investors and pension funds who handle our pension money without an alternative source of higher returns and under big pressure to step up investment skills. Too many institutions relied on investing assets with the fund of funds – for which they paid over the odds – rather than their own analysis.

As the economy contracts, so will the pressure increase on fund managers to deliver greater returns. But until they do the outlook looks gloomy for the generation retiring today which has seen its stock market investments lose the gains of the past few years – worth the same now as this time last year.

There are a few glimmers of hope. Stock market historian David Schwartz has looked back at the 18 bear markets of the past 100 years and reckons we hit the low at the end of November when the FTSE100 index had fallen, year on year, by 44 per cent. He suggests that after a few volatile months we will see the beginnings of the next bull market, assuming there isn't another, unseen, disaster lurking in the banking system.

Schwartz even gives a prediction – the FTSE100 up at 5300 by the end of next year. Now that is good news.

Five to watch in 2009: Who's who – from high street to outer space

Stephen Hester, the new chief executive of Royal Bank of Scotland, has one of the hottest seats in British banking following the Government's £37bn recapitalisation scheme which saw it take majority control of RBS. He has already cut hundreds of jobs.

Sir Stuart Rose is chairman and chief executive of Marks and Spencer. He has to find a new chief executive to direct the retail chain – and must prove he can compete with lower-cost retailers, such as Tesco and Netto, who are gaining ground during the recession. Some analysts wonder if he can survive.

Willie Walsh, chief executive of British Airways, is still king of the British airways but needs to demonstrate that he can compete internationally. He is in merger talks with Spanish airline Iberia, but must move quickly to show he is still a player in an industry set to contract sharply.

Dame Clara Furse, chief executive of the London Stock Exchange, has played some smart moves. But she has missed out too. For example, the German exchange is still looking very lonely, and bringing it into the LSE's orbit could decide her reputation.

Sir Richard Branson is one to watch closely this year – his empire stretches from media to space, with Virgin Galactic. His is one of few businesses still to have cash, so what he does with it will be fascinating to follow.