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Summary of key points
- There is a global shortage of inflation and consumer spending. China, Japan and Europe are competing to export deflation and import inflation via looser monetary policy and falling exchange rates.
- This global shortage of inflation has caused the US Federal Reserve to defer an increase in short-term interest rates off the floor where they have been since 2008.
- This has caused a significant shift in financial market conditions over the last month or so. There is now an increased flight to safety in the form of higher allocations to long-term bonds by major institutional investors worldwide. This is offsetting risks of an increase in bond yields that had been identified previously.
- Bond yields are now more likely to stay low or even fall slightly, rather than increase over the next three years. This makes equities, particularly in the USA and Australia, more attractive than we had previously assessed.
- The patient accumulation of cash in recent times of falling and unstable equity markets is now likely to be rewarded by increasing the allocation to equities, which, most of the time, in the longer run, provide superior returns compared with cash or fixed interest.
- Over the next year, caution is still needed because no major developed equity market is particularly cheap on a scenario-weighted basis, although the Australian and US equity markets are less expensive than other markets.
- There is still the prospect of volatility in major stock markets in the months ahead, so it would be prudent not to be overweight in equities yet. Such a move to overweight could be considered if equities prices pull back by 10% or more below the current level. Given the continued volatility of markets and the fragility of the economic recovery, such a pull back in equity markets is quite possible over the course of the next year
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