Investments: the strategy to be pursued this autumn

As we have witnessed with currency movements and the spike to all-time highs in yields on sovereign debt issued by so-called peripheral eurozone member states, a fresh policy mix urgently needs to be formulated and implemented by governments and central banks. Although central bankers do enjoy some room to manoeuvre, government policymakers' hands look more securely tied by mushrooming public debt, budget deficits and the array of austerity fiscal packages.

So why is there such an emergency need for a fresh policy mix? Primarily because deflation is spreading its tentacles through three main channels. Firstly, jobs are just not being created in economies. Some 9 million or so jobs have been lost in the USA over the past 18 months. So far, there has been no evidence of any noticeable upturn on the employment front. Jobless rates in Europe are still pretty high too.

Secondly, the lending cycle remains jammed. Evidence of this can be detected in the very low percentage (just 25%) of American small businesses successfully securing loans. Thirdly, housing markets have not yet bottomed out on either side of the Atlantic. As housing accounts for the biggest chunk of households' financial assets, the ongoing slide in the value of their homes is creating a negative wealth effect.

The combination of this trio of factors is playing havoc with homo economicus's spending patterns: anxious about the value of his home and worried about his job security, he is tending to save rather than spend. As consumer spending accounts for almost two-thirds of GDP in advanced economies, growth in Q3 2010 looks set to slacken to only around 1.5% in the USA and to just 1.2% in the eurozone.

So, unless we see some fresh reflationary impetus, growth rates could even sink back into the red zone. But what form could these extra stimuli take? Three possibilities look plausible. 1) Central banks and governments could take concerted action to put in place new plans to revitalise economies. 2) Monetary authorities could act alone, i.e. without governments hamstrung by the huge public-sector deficits. 3) The powers-that-be waver in implementing any new measures, which would be tantamount to committing a serious economic policy blunder.

As the third scenario would, to all intents and purposes, condemn economies to a double-dip recession and as the first looks most improbable, we believe that the second scenario seems the most likely outcome. To counteract the deflationary tide at work, the Fed and the ECB are going to have to take action quite smartly before this year is out.

However, some members of the Federal Open Market Committee (FOMC), as exemplified by comments made by Fed Chairman Ben Bernanke at the Fed's Annual Jackson Hole Symposium on 27 August, would appear to want to see more palpable evidence of the slowdown materialising before pushing through any further stimulatory measures. The political agenda will not help matters either as it is most unlikely that any action can be taken before the mid-term Congressional elections scheduled for 2 November. Once that date has passed, the situation in the USA will have become even more urgent as tax cuts implemented by George W. Bush in 2001 and 2003 are not going to be renewed as from 1 January 2011. Moving to Europe, although peripheral eurozone governments are still experiencing financing troubles, the ECB will have to take steps.

Now we have to assess what implications all of the above are likely to have for investors and investment. At present, the level of yields on long-dated US and European sovereign bonds has priced in the double-dip scenario. Yields are thus likely to remain volatile over the coming months, as will share prices which can be expected to be range-bound within a corridor of plus or minus 15%, with swings likely to be quite violent as equity markets alternate ups with downs.

Given this outlook, corporate bonds look quite attractive propositions. Credit spreads on corporates are currently still pitched above historical averages whereas company balance sheets have, more often than not, been considerably rehabilitated and reinforced. As investors' aversion to risk remains pretty high, safe havens such as the US dollar, Swiss franc and gold should also, from a fundamentals vantage point, extend their good run of form.