SUMMARY There is an eerie calm in stock markets, but UK and US government bond yields are sending a more cautious message. As is Ben Bernanke, the major hedge funds, and the economic stats coming out of the States (to name but three!). As the song said “There are more questions than answers”.  P.S. If you haven’t done so already, email back to request a copy of the latest TopFunds Guide, which covers these issues in more detail.

The FTSE 100 index remains up 50% from its low in March 2009. This bounce reflected low valuations in the Spring of last year and anticipated the storming profits recovery which has been evidenced so far in 2010. There is now an eerie calm after the extreme turbulence of May, when Greece put markets into a spin.

In a benign low inflation environment equities (particularly high yielders) should look attractive, particularly with bond yields continuing to hit record lows in recent weeks. But what if bond yields are this low (lower than midst the turbulence of 2008 when there was a rush to buy) because they are expressing more caution than equities, acknowledging the likelihood of an economic slowdown in the months ahead, and fearing deflation?

Deflation is an economic and behavioural phenomenon. One in four aged 18-29 in the US have moved back in with their parents, and a fifth of Americans suffer negative equity. In the UK creeping austerity has seen powdered custard sales up 117%, sales of cheap cuts of meat are booming, and consumer confidence lower than it was a year ago (in contrast to the enthusiasm of the stock market). Consumers represent about 70% of economic activity – in this increasingly cautious environment are they likely to spend more or less?

A prolonged period of deflation would be dangerous, as it encourages a vicious circle of purchases being postponed, prices being cut, employees being laid-off, purchases being postponed and so on.and this behaviour tends to become entrenched. The authorities understand this, which is why further rounds of quantitative easing (QE) must be expected, even though it remains a huge experiment.

If there was more QE (especially in the US, but also UK) it would have the effect of government bond yields going lower still, plus more money being pumped into the economy tends to show up first in the stock market (as happened with the sharp rise from March 2009). On the face of it this could justify what we are seeing now, with bond yields already hitting new lows, and stock markets still holding up.

But if the market is holding up because of speculation of more QE, this is a far from solid foundation. Moreover the volume of trading in the US stock market fell sharply last month as the index recovered from May, so not a lot of conviction is implied. We also know that the largest hedge funds have been reducing risk in portfolios in recent weeks, some with sharply increased cash holdings.

If you get the sense that there are many more questions than answers, then we are in agreement. Ben Bernanke surprised everyone by expressing a similar sentiment. He said baldly that there is “unusual uncertainty” (because record stimulus applied to the US economy has failed to trigger a self sustaining recovery, and their economy is heading south again). And if you de-code the Federal Reserve minutes from June they tell us that the US economy may not recover until 2016.

Volatility may have gone on a summer holiday – but that doesn’t mean you can stop paying attention to unfolding events.