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Reasonable doubt

Risk and cyclically sensitive assets such as equities, credit and commodities have enjoyed a recovery during the second quarter of this year as fears of systemic failure in the financial system are replaced by hopes that the global recession is coming to an end.

Despite a significant market rally, we are still some way from pre-Lehman levels across asset prices and economic indicators, which is seen by some as a bullish precursor to a market normalisation. Our view, however, is more cautious in the near term and we feel investors may now be too sanguine on the economic outlook and risks.

The Lehman collapse led to a seizure in credit markets. The huge drop in output – leading to double-digit annualised declines in GDP – created a massive overshoot to the downside in many market and economic indicators.

Decisive action taken by authorities in monetary and fiscal stimulus, as well as intervention in the banking system, financials and manufacturing, has restored some confidence and ensured that credit, the lifeblood of the economy, may begin to flow, albeit slowly, once again.

From artificially depressed levels of activity, we have enjoyed a bounce, as most economic indicators have moved higher from often record lows and begun to look to a period of expansion. This period is still some months away but the V-shaped recovery seemed inevitable, given how low indicators had fallen and, importantly, due to the inventory rebound now pushing growth towards positive territory.

How sustainable will this economic upturn prove to be?

We believe the initial V-shaped recovery will give way to a more turgid backdrop. It will likely be some years before the global economy returns sustainably to trend rates of growth as deleveraging progresses, demand for credit remains muted, access to credit is relatively low, capital formation is low (due to oversupply in property and excess capacity) and consumer demand is weak.

That said, we will see a return to positive growth in many economies in the next quarter and many emerging areas should remain relatively robust, giving credence to the decoupling theme.

The economic and corporate backdrop is more positive now than at any point since Lehmans went under. Nonetheless, having been underweight equities for much of 2008, and overweight through the rally, positions on risk should be reined in.

US equities are trading on 15.5 times trend earnings, just below long-run average levels, and credit markets have moved from pricing in defaults consistent with depression to a situation more aligned with severe recession.

There is enough of a valuation gap in equities to warrant the expectation of good longer-term returns both in excess of cash and government bonds but we are a long way from the unconditional value offered just two to three months ago.

We continue to favour emerging markets and remain negative on Europe and the US. We are reversing our long position on UK equities, partly in response to the rapid rise in sterling. We expect the dollar to weaken over the longer term but there is scope for outperformance of overseas assets in sterling terms and the UK equity market now has no clear relative attractions on an unhedged basis.

We are nearing the end of the market rally. Such rallies can be huge but it is rare to get one as explosive as we have seen in such a short timescale.

From here, with valuation broadly fair and limited scope for upside surprises in economic and corporate newsflow, we see the risks on equities and credits as much more finely balanced.

History has shown that the authorities have tackled each crisis with the inflation of a new asset bubble. To move much higher in the short term, beyond an overshoot and into a new bull market, will require fundamental improvement beyond what is reasonable to expect.

Paul Niven is head of asset allocation at F&C

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