The bust phase of the cycle occurs when central banks increase interest rates (i.e. the yield on money) to slow the boom phase of the cycle and the risk-adjusted yield on money rises higher than the yield on less liquid and riskier assets. Capital flows to the left – fleeing overvalued bonds and risky capital investments in real assets such as land, labour and capital investment projects. This phase of the cycle is characterised by a rush for liquidity and by financial distress.

In our last update in June, we used the portfolio balance approach to justify our recommendation that clients should feel comfortable taking on risk in their portfolios. Back in June, global central banks were raising interest rates very aggressively and risky assets were volatile. This rise in yields on money and bonds contributed to the volatility because it was raising their risk-adjusted yield compared to the riskier assets such as emerging market debt and equities in general. Some investors were questioning whether we were on the doorstep of another investment bust.

Our analysis suggested that that the yield on money and bonds was still low relative to the yield that could be achieved in less liquid and riskier assets like emerging debt and high yield bonds. There was still enough capital to flow to the boom phase of the cycle. Since then, the riskier segments of the global bond markets have performed very well and financial market volatility dropped to new lows for the year.

Looking forward to 2007, the recent drop in global bond yields is encouraging for risky assets but we would expect more financial market volatility compared to the second half of 2006. The US economy is at a critical point in the cycle, caught between the cross currents of a strong corporate sector but weakening household sector.

Bond yields have been driven lower as speculators flee the residential property market. Once capital gains stopped in the real estate sector, the yield on property investments collapsed and liquidity started flowing towards the bust phase of the cycle, seeking the higher risk-adjusted yields on money and bonds. The drying up of speculative capital in the real estate sector is significant because it has been such a long and powerful boom. The capital gains from the real estate sector were a powerful wealth effect that sustained investment and consumption over the last few years. Going forward, consumers in the US are likely to raise their level of savings because of the negative wealth effect and that will now act as a drag on consumption.

We expect global demand to undershoot consensus growth expectations in 2007. This will help reverse the tide of rising global policy rates even though the European and Japanese central banks continue to be very hawkish. The Federal Reserve is likely to actually start cutting interest rates in the first half of 2007.