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Morning after

The second quarter of 2009 saw a strong recovery in risk assets as fears of systemic failure in the financial system gave way to hopes that economic recovery is imminent.

Recent asset market moves have been extraordinary. The S&P 500 index in the US moved from a low on March 6 of 683.3 to 892.72 on June 23, and many emerging markets have shown even greater gains. Credit spreads have tightened and economically sensitive commodities, such as oil, have doubled from lows.

That markets are still well below their pre-crash highs is leading some investors to believe the recent rally in risk assets is the beginning of a new bull market. I cannot help feeling rather more cautious. A V-shaped economic recovery may be inevitable given how low many indicators had fallen, but the question for markets is just how sustainable this upturn will be.

The debt explosion of the past 25 years was unprecedented and some potentially painful and prolonged deleveraging now seems unavoidable, particularly for households. The debt hangover is another reason for fearing the US and UK may still be years away from a meaningful recovery and deflation remains a serious threat.

In 2007 the US ratio of debt to personal disposable income was 133 per cent, around double what it was in the mid-80s. To reduce this back to 100 per cent would require a huge fall in household debt. The only painless way to achieve this would be to reduce the real value of debt by allowing price and wage inflation to run at a faster pace. However, it seems likely the Fed will struggle to generate even normal rates of inflation in the next few years, let alone unusually high levels. The danger now is that falling prices and wages will become a permanent part of the economy, as they are in Japan. In a worst-case scenario, the US could yet slip back into the sort of debt-deflation spiral that characterised the Great Depression.

I believe we are coming to the end of a rally that has been unusually explosive for such a short period of time. However, economic and corporate newsflow remains poor and valuations broadly fair, meaning the risks between equities and credit are much more finely balanced.

Sam Liddle is fund manager of CF Miton global and CF Miton cautious income at Miton Asset Management

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