Thanks to the efforts of Central Banks and Governments around the world in the form of massive interest rate cuts, quantitative easing and huge fiscal stimulus packages economic activity has finally pulled out of the nosedive that it spiralled into.

There has been a significant pick-up in global purchasing managers’ indices as companies start to replenish their depleted stocks.  There has also been a rise in business and consumer confidence.  Credit markets are beginning to thaw and there is evidence of a return to banking profitability along with stabilisation in house prices on both sides of the Atlantic.

Despite such signs of improvement, the road to economic normality is likely to be long and bumpy

Although purchasing managers are ordering again, industrial production is still way down on a year ago.  Also, consumer confidence, although higher than the dark days of March, is still significantly lower than ‘normal’ levels, as consumers continue to face stagnant income growth, high and rising unemployment and damaged net wealth. Moreover, despite an easing in credit markets and a return to profitability for many banks, money still remains very tight.

Slowly but surely financial and economic conditions will continue to improve and economic activity will eventually return to trend levels.  But the chances are that the new trend will be lower than in previous times. Government debt as a percentage of GDP is likely to escalate from an average of approximately 75% to an average of 150% in a worst-case scenario. However, the price that will have to be paid is higher bond yields and higher taxation.

Emerging economies, on the other hand, are less likely to be affected in the same way

Their banking systems were less influenced by the sub-prime crisis and government debts as a percentage of GDP started off much lower, at approximately 38%, and are forecast to actually fall as a result of continued robust growth.

In an environment in which advanced economies are only just starting to turn the corner and face significant headwinds going forward, inflation is unlikely to be a problem for the immediate future. In fact, the current threat is actually deflation: prices are falling in the US and the UK (on the Retail Price Index) for the first time in over fifty years, Japan is also experiencing deflation, and the Euro-zone has zero inflation with the expectation that it, too, will slip into deflation.

So what does this global economic outlook mean for asset values?

Looking at equities, approximately 75% of companies in the S&P500 index and 50% in Europe beat earnings expectations in the second quarter of 2009. But, expectations were very low to begin with.  Moreover, company revenues were actually lower, indicating that profits were maintained through aggressive cost-cutting.  At some stage, revenues will have to rise in order to boost company earnings, and this is likely to happen in the next few quarters.  Given continued decent growth in emerging economies, the demand for raw materials will remain robust making the outlook for commodities positive, albeit with significant volatility.  The best investment value at the moment lies in corporate bonds.  On a risk-adjusted basis and given that equity returns are likely to be only average going forward, corporate bond investors can expect equity-like returns but with much lower volatility and greater security of capital because corporate bonds lie higher up in the capital structure of a company.

In summary

The global economy has turned the corner, financial and economic indicators continue to improve, and risk appetite is slowly returning.  However, significant headwinds remain, making the road to economic normality long and bumpy. Consequently, although investment opportunities will improve, volatility will remain somewhat elevated for a while. It makes sense, therefore to adopt a multi-asset approach to investing with a tilt towards assets with the highest risk-adjusted prospective returns, such as corporate bonds, whilst maintaining the flexibility to dynamically switch between asset classes so as to navigate successfully through challenging times.

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