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Lost in Paradise

Paradise regained. Perhaps. Perhaps not, on reflection. Having been at an extreme of bearish sentiment in the early summer, investors now seem to have donned rose-coloured spectacles, believing the world’s central banks have engineered the perfect soft landing for the US and global economies, with equities almost celebrating the prospect of slowing growth and slowing earnings’ growth.

Bond markets have retained some scepticism about the prospects for inflation but even here the central bankers have been given the benefit of the doubt. Risk is a word that seems to have passed from use in polite investment circles, as markets seem immune to virtually all types of investment risks.

Ignoring the mounting risks in the economy will eventually exact its toll. Central banks everywhere are normalising monetary policy and even though the Federal Reserve is pausing in its tightening for now, the recent dataflows suggest that inflation is far from tamed. As a result, we can expect further rate rises but, more important, much more draining of liquidity from the world economy next year, even if headline rates move little.

In the immediate future, the outlook for the run-up to the end of the year is benign as the reporting season for the summer quarter should still support equity markets. The problems are most likely next year as the welcomed slowing hits earnings at the same time at the liquidity drain removes some of the fuel for markets. The old imbalances will come back to the fore in investors’ minds as the economy reminds us it is far from perfect. Other old worries, such as current account deficits and government budget deficits could resurface as the core inflation rates prove hard to move back to a downward track, despite easing commodity prices.

However, old habits die hard and the custom of the year-end rally will likely be observed this year too. Given the underlying flaws in the rosy scenario and chances of unexpected risks to the world economy, Paradise really has yet to be regained but perhaps we still have a chance to avoid the awful alternative further out if we remain vigilant and act to remove the lurking risks.

Justin Urquhart Stewart is director of Seven Investment Management director

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