The last three days of market selloffs (-3.4% in the S&P500, -4.4% in Europe, or -4.2% for the BRICs) has generated a debate on whether we are in for a more serious pullback. Some are saying that the rally had not been for real nor based on fundamental improvements. Numbers like “another -10/-20%” are being mentioned in the media. Investors following that line of argument are bound to shy away from risk, increase cash and exposure to short-term risk-free rates. Others can call it ‘profit taking’.

Our core views remain consistent with the ideas expressed here since last November, some of which are now part of mainstream (you are invited to read them below). OK, enough marketing, let’s go to the main point.
Our core view is that the recovery is under way, it is for real, but it will show mediocre growth rates in G7 and better ones in the good EM countries. We are in the upswing of a business cycle, though the downturn had not been generated by a standard shock to the system. We continue to fear inflation in those countries that responded to the crisis with serious fiscal and monetary expansions, which is why we favor commodities, short duration bonds, inflation linkers and currency diversification away fro G3.

Economic data has been showing signs of hope since early July, globally. Momentum is broadening. It can be interpreted as the result of all that stimulus in the US and Europe, but we think that interpretation is missing some relevant data points. Economic observers tend to look at demand indicators, placing too much emphasis on the consumer. But the supply side is equally important, and tends to be overlooked. The last earnings season show profits coming back, especially in the US. True, it was mostly based on cost cutting and little on revenue increases. But that is not necessarily a negative, as it shows how flexible and quick to adjust is the US economy. Additionally, productivity growth (the real engine of growth) has gone back up (the US just reported the second month of 6.5/6.6% productivity growth). Manufacturing is maybe the first sector to show increased production, and data watchers are forecasting 3% growth during the second half of 2009 in the US (annualized rate). Growth forecasts tend to be higher as further away from G3 we move.

Thus, on the positive side we have economic data globally, especially that from the supply side. On the negative side we have fears that banks may still have losses to come from commercial real estate, fears of inflation and dollar depreciation due to deficit financing, etc. Not to mention some policy uncertainty, especially in the US and Europe (Health Care reform?).

Our portfolios reflect that with an equity allocation of 25-30%, with a special emphasis on regional diversification to Asia and Emerging Markets. Our commodities allocations are reaching 15% (including agro, energy and materials). Within fixed income we maintain very low duration, and we do not think it is early to own inflation linkers (between 5 and 10%). We maintain exposure to corporate bonds, both in investment grade and high yield (still low duration). Liquidity or cash is in the 10-20% range (depending on the portfolio).

Clearly, the path out of the most important global crisis in almost 80 years will not be smooth or always clear. But our main belief is that last year’s financial crisis did not break the main sources of productivity growth, innovation and creativity. It did destroy wealth, as well as damaged the more complex angles of the financial markets. Though the basic method to allocate savings to investments seems clogged, we do not think it is broken. Credit markets have normalized to a large extent (spreads are back to “normal” levels), and will continue to do so, allowing for investment rates to recover.

Thus, caution should be maintained, with eyes on increasing risk by reducing the cash levels. The equities allocation together with the commodities allocation do not imply a high level of exposure to the market, and a September pullback could prove to be an opportunity to increase risk.