Access 'Economic Viewpoint - June 2009' here

Global: Risk appetite returns, but for how long?

• Increased expectations of recovery, evidence of financial stability and an improvement in liquidity have driven markets over the past quarter. Led by the emerging markets, equities have trounced government bonds and commodity prices have risen as investors have bought into the reflation trade.

• Supported by the inventory cycle, recovery expectations are likely to continue to build and there is little sign that central banks are about to turn off the liquidity tap to markets. This would support the reflation trade through the summer.

• However, in recent weeks equity gains have slowed, suggesting that investors have begun to question the strength of the recovery. Analysis from the IMF (International Monetary Fund) clearly shows that recoveries from financial crisis are weaker than those in conventional cycles. Periods of synchronised financial crisis, such as the situation today, tend to be the weakest of all (see chart below).

• Should the recovery falter, there would be talk of a double dip and deflation. Policy makers would find themselves on the back foot having used most of their ammunition in cutting rates to zero and embarking on Quantitative Easing (QE). Investors have rightly discounted the probability of another Great depression, but are not sufficiently confident to take the next step and price in a robust recovery.

Focus: Great (inflation) expectations

• It seems only yesterday that worries over deflation dominated sentiments across the world. However higher commodity prices and growing optimism have prompted markets to raise their expectations of inflation over the medium term.

• With higher inflation expectations, markets are pricing in earlier rate rises. Futures markets imply rate hikes for the UK as soon as the fourth quarter of this year. We feel this is too soon and the ongoing need for deleveraging will keep rates low.

• Ultimately, higher inflation brought about by higher commodity prices, acts as a tax on consumers. Coupled with low capacity utilisation this will mean a very large output gap, which is bound to exert significant deflationary pressure. However, should commodity inflation outweigh the deflationary pressures mentioned above, then the world is in for a painful spell of stagflation.