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A potent mix

In Greek mythology Cassandra predicted the fall of Troy but no one was prepared to listen. She might have fared better in 2010 when market participants seem all too keen to cling to proclamations of doom. Nervous investors have resisted the attractions of the equity market for much of 2010, preferring to pour money into government bonds, despite their historically low yields. But more recently it is policymakers who appear to view every slowdown as the advent of a double-dip recession, seemingly ignoring strong corporate results and building inflationary pressures.

Their desire to micro-manage the economy to avoid a double-dip means that further quantitative easing is a fait accompli. Whether the additional liquidity is needed is a moot point but its effect on asset markets is already being felt in the autumn rally.

A fitting comparison with today’s economy might be the path of the global economy in the mid-1970s. Back in 1973, Opec’s oil embargo triggered high inflation, caused stockmarkets to nosedive and contributed to the rapid deterioration in industrial output from the G7 group of countries. This collapse was followed by a sharp rebound and then by a period of more prosaic growth.

The output path during the recovery phase in the 1970s is remarkably similar when plotted against the current trend and offers us some indication of what is to come. There is a similarity between the V-shaped recovery experienced then and the path we seem to be taking today. Leading indicators appear to reinforce the view that the slowdown in growth is suggestive not of a double-dip recession but rather a period of more pedestrian growth – a trend that we expect to continue among the Western economies until 2012. Fortunately, we believe emerging markets are in a stronger position this time around to pick up some of the slack.

Even accounting for a slowdown in the pace of economic growth, the fundamentals of equities look compelling. The yields on equities are attractive relative to bonds and cash and with European and UK equities trading at close to 11 times forward earnings, equity markets seem to be at the bottom end of their valuation range.

Equity markets may have rallied recently but heavy purchasing of government bonds indicates that investors remain cautious. Such caution suggests many equity buyers are still sitting on the sidelines and, combined with potential liquidity injections, this can present a potent mix.
The danger is that liquidity injections may work too well: while markets in the West may move comfortably higher, the additional liquidity could create bubble conditions elsewhere. Expect more countries, particularly among emerging markets, to be forced to engage in capital controls and currency wars as they try to counter the unintended consequences of double-dip pessimism.

Mark Harris is head of multi-manager funds at Henderson Global Investors

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