LAST year was a challenging one for the UK. However, as the New year begins, it is becoming clear that the UK’s modest recovery has gathered a bit of steam – with GDP looking to have grown around 1.7% in 2010 compared to 2009.

Consumer price inflation, however, seems to have turned out less positive. It has failed to ease in the way the Treasury had predicted it would and ended 2010 running around 3.4%.

So what will happen this year? We believe that 2011 could be a rougher ride than is generally expected.

The assessment of the Office for Budget Responsibility (OBR) for a fairly nice outcome over the next two years – with decent growth, inflation dropping back on target and the deficit falling fast – may prove overly optimistic.

Firstly, fiscal tightening in the form of spending cuts and VAT and other tax rises will hurt and could dent GDP more than expected.

Secondly, there is the possibility that sterling could fall. A drop in sterling would usually help UK firms price themselves back into world markets, but for various reasons they are likely to continue finding the going tough.

And, finally, there are additional reasons for some gloominess surrounding inflation as survey data seems to support the notion that there is little spare capacity out there.

What this means is that excess supply will not be able to exert much downward pressure on consumer prices or corporate margins.

As such, the “bump in the road” facing the economy in the first months of 2011 may be bigger than expected, although we doubt that it will derail the economy altogether.

The credibility of both the Chancellor (and his efforts to eradicate the budget deficit) and the Bank of England (to keep inflation close to 2%) could end up being stretched, but certainly not broken.

What this means for markets is that any fears surrounding the sustainability of current policy could increase in the first months of 2011, leading to a realisation that the UK will not be fully “out of the woods” soon.

As regards equities, firms may be hedged against UK-specific risks by their overseas earnings. The call on gilts is a little more difficult.

Slower growth would hurt them, but worries about the deficit would harm them. Overall, we would sit tight but prepare for some volatility.

Andrew Miller is regional office head of Barclays Wealth in Newcastle