The still incipient September market recovery appears to respond to data that negates the double-dip view and increases credence to the gradual recovery view. Our approach has been to cautiously position for the latter, within a broader theme of a structural change in favor of EM and other non-G7 countries. In other words, we continue to believe in a sub-par recovery for G7, while we see (and maybe thanks to) higher growth in the best emerging markets and non-G7 developed countries. Capital reallocation away from G7 is bound to be structural, not only cyclical. This is already a fairly mainstream view, and market prices and performance are showing it.

We see the volatility of the last 6 months as the result of the natural confusion that emerges at the outset of a medium-term structural change. Especially one that happens while the traditional core markets suffer from mediocre fundamentals. G7 fixed income funds are unlikely to quickly adapt to a world in which the USD and the euro lose value vis-à-vis the currencies of the best EM or other fiscally sound developed countries. Same with equity funds. But the change is starting to happen. Thus, concerns about a double dip in the US (or sharper deceleration in China), right after the EU faced severe institutional challenges, amount to serious shocks to a still crisis-sensitive market. As data in the US and China improve, albeit very gradually, and Latin America and the rest of Asia continue to show decent growth, markets should stabilize and this structural change will continue.

Moreover, recent policy signals from the US and data from Europe are bound to accelerate the capital reallocation away from G7.

The US is clearly on a lax combo of monetary and fiscal policies, which tends to weaken the dollar. Recent announcements by the Fed confirm that there is no rush to design or implement an exit strategy for the more than $1 trillion expansion of its balance sheet. Actually, the Fed stated that it could do more on the expansion side if the economy decelerates further. On the fiscal side, the medium-term sustainability debate has begun, but those advocating for a sharp fiscal adjustment as a boost to confidence that could be better for growth than more stimulus are not bound to get anything serious done soon. Moreover, the exodus from Obama’s economic team (Orszag, Romer, Summers) could be the beginning of a serious change, or just a mid-term change of personel. This is a non-trivial source of uncertainty that is added to the taxation uncertainty. The November elections could be good news, but far from a clear step towards medium-term sustainability. We maintain our view that the US economy remains the most flexible and capable of tacking away from unsustainable deficits, but there is no evidence yet that we will see it happen soon. But the US equity market is bound to remain and increase its role as an efficient partial vehicle to invest in the rest of the world (companies derive a high percentage of revenues from their international activities).

European data has started to show deceleration, proving the rule of thumb of a six-month lag to the US economy. The fiscal restrain from the north of Europe, as we highlighted before, puts a floor on the euro/USD rate, and is bound to continue to work on euro’s favor. However, the EU institutional challenges, together with the still high probability of a credit event from a portion of the problematic set Greece+Spain+Ireland+Portugal, is enough to prevent us from diving back into Europe.

The question is how much to push the tiller towards the rest of the world. We have chosen a cautious approach, as volatility patterns maintain significant inertia. Upon any global shock, G7 markets maintain lower volatility than the rest. But the more recent Fed statements, together with the fiscal uncertainty (Bush tax cuts, further stimulus, and the economic team exodus), while Europe decelerates, calls for a reduction of that cautiousness.