The high volatility of the last few months has generated panic moments in the markets, perceived uncertainty about future scenarios, and sharp inconsistencies in some of the public policy debates. Though there are reasons to marginally re-shuffle the probability distribution among the most likely scenarios, there is no real reason to change the base-case scenario. The easy part of the post-crisis recovery is behind us (it ended sometime between January and March), leading to years of more complex issues and convoluted markets. To invest through the most likely scenarios ahead, trust in a consistent view of the world is required. That view would obviously get re-assessed frequently within a logical analytical framework, impervious to short-term noise.

The issues to assess for the medium term are not all linearly connected. Thus, let us first summarize the view, and then a list of some of the issues.

We continue to believe in the economic recovery, albeit a non-traditional distribution of growth, but consistent with our view of the world since December 2009. We continue to expect sub-par growth in the US and Europe, higher growth in the rest of the developed world (those less affected by the last crisis), and continued convergence among the best emerging markets. Paradoxically, the source of policy uncertainty has changed recently. Europe has suddenly dressed itself in fiscal discipline, signaling its move towards medium-term sustainability, while the US produces concerning signals on the subject. Tax policy in particular, and fiscal policy more generally, is maybe today the key source of uncertainty for those about to make economically relevant decisions. This view of the world has significant implications for currency and equity markets when it comes to maintain wealth in real terms.

Some of the relevant issues today are:

– Data has recently confirmed the severe economic deceleration that happened during the second quarter, especially in China and the US, with some follow through in the rest of Asia. Latin America does not seem to follow, while its inflation appears to be moderating in the short-term (Brazilian interest rates are a prime example of a recent move along those lines).

– Deceleration does not mean double-dip. History shows very few examples of double-dips so early in a recovery. Moreover, in a recent but already famous book (Reinhart-Rogoff, “This time is different: Eight Centuries of Financial Folly”, Princeton 2010), one of the stylized facts the authors highlight is how slow post-crisis recoveries are. There are obviously counter-examples, especially cases where the GDP contraction had been extreme (note that they refer to financial crisis only).

– US data continues to show health in corporate spending, especially compared to previous recoveries. The corporate sector is particularly healthy this time around, with plenty of cash and comfortable liability profiles. Cash in corporate balance sheets exceed 1.8 trillion dollars, which starts to be tapped as demand recovers (M&A, equity buybacks, expansion, etc.).

– China’s engineered deceleration is maybe the most prominent source of uncertainty. Given the recent results, further policy initiatives should not be expected. Growth is now forecasted in the 8% area, which is clearly not low enough to whine about. Data is starting to show a subsequent marginal deceleration in the rest of Asia.

– Tax and fiscal uncertainty is maybe one of the key issues. Europe has surprised us with its new fiscal zealous. There clearly are risks in Southern Europe (Greece, Spain, Portugal, etc.) and Ireland, where a credit event cannot be ruled out. But Europe as a whole has taken significant initial steps towards fiscal solvency. At the same time, the fiscal debate in the US indicates not only no urgency, but even the possibility of further stimulus before belt tightening begins. Because of these differences in attitudes towards fiscal imbalances, we no longer expect the euro to trade towards 1.1, but would still not dive to the currency. We have re-entered European equities through the largest companies in the region (at prices still 10% below we exited the same index, being today maybe the cheapest sector from a fundamental point of view). Our views on Europe’s institutional challenges have not changed. The rescue package has bought them almost 2 years to address those issues.

– This side of the Atlantic, the US has become a non-trivial source of micro and macro uncertainty. On the macro side, the government has clearly decided it is too early to send fiscal austerity signals. We regret to admit that on this debate our views are more consistent with what the Europeans are doing (austerity reduces fiscal uncertainty, which leads to growth). On the micro side, tax policy remains uncertain, especially on the elapsing Bush tax-cuts. It is very likely that parts of those tax cuts are extended, as a way to stimulate the economy. At the same time, it is fairly clear that taxes would have to eventually go up. This generates uncertainty that affects relevant economic decisions (investment, work, consumption). The November elections can mean that this uncertainty will extend through those elections.

– Monetary policy is where there are neither dichotomies nor ambiguities. G7 has clearly signaled that monetary expansion remains for the foreseeable future. There are neither plans nor urgency to withdraw it. In fact, monetary policy can be more effective than fiscal policy in reducing the economic deceleration witnessed today, which is why we prefer the European model. What matters here is global liquidity and what it means for asset prices.

– Europe will this weekend publish the results of the ‘stress-tests’ on 65% of its financial system, aiming to increase transparency and calm markets. Critics have already highlighted that the test was not stressful enough, which is very likely. But we believe those results are bound to calm markets, at least as a reduction of the uncertainty about the actual size of the problem at hand (especially in the German Landesbanks and Spanish Cajas).

– Corporate earnings continue to be positive for the market, though not enough to counteract all the other sources of uncertainty.

– Equity markets tend to show falling P/E rations during periods of slowing growth. But current ratios are a bit too low for historical standards, as they point to even lower earnings. In a recent piece from Citibank, using a combination of ratios to book values and earnings in a global historical context, they conclude that the MSCI ACWI index is 30% undervalued. We leave aside the implications for different regions and sectors for now.

Conclusion: we remain cautious about the markets (15% cash, equities not higher than 20%, commodities around 8%), but with an optimistic bias, which has led us to increase our exposure to European conglomerates (S&P100 Global has significant exposure to those); our optimism vis-à-vis the redistribution of growth towards emerging economies consolidates, leading us to maintain or increase our positions there (currencies, interest rates and currencies).