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The world economy is showing signs of a surprisingly rapid deterioration. This poses a serious challenge to policymakers worldwide, as their room for maneuver has narrowed. Against this backdrop, the European debt crisis is likely to worsen. On a more positive note, inflationary pressures in emerging markets are set to weaken, which is a most welcome development.
Equities have suffered badly over recent months and we believe it is still too early to anticipate a rebound. In the short term, we think that the risk of another downward move is somewhat larger than an upward move. Key factors here are the ongoing worries about the state of the global economy and the deepening concerns about the eurozone debt crisis.
Although we think that government bonds are overpriced and unattractive in the long run because of long-term inflationary risks, it is too early to write off the asset class. We believe that the increasing stress in the eurozone will prevent bonds from falling.
The outlook for corporate bonds has become challenging. But this has already been reflected in the sharp rise of credit spreads. We feel that current spreads are reasonable in this environment. Elevated levels of uncertainty are likely to continue.
Within equities, we maintain our preference for defensive sectors over financials, despite a performance gap of around 20 percentage points in favor of the former over the last six months.
There has been increasing market talk in recent months about stocks being cheap. In this month’s Special, we make the case for focusing on absolute valuation. At current prices, this metric suggests that equities are neutrally valued. An analysis that uses trend earnings over the last 30 years comes to a similar conclusion.