Asset Returns in a Deleveraging World

The global economy has been navigating choppy waters recently. Despite accelerated deleveraging and a slowdown in economic growth, financial assets have surprisingly held their own in 2011. This might seem counterintuitive, but understanding how different asset classes are impacted by shifting economic conditions reveals a more nuanced picture.

Bridging the Gap Between Perception and Reality

Most investors tend to focus on equities due to their perceived high risk and return potential. This can lead to a skewed view of overall market performance. A balanced mix of assets, however, has actually performed quite well this year. This begs the question: why are some asset classes thriving while others struggle?

Dissecting Asset Returns: Growth, Inflation, and Risk Premiums

The key lies in understanding how factors like discounted growth, inflation, and risk premiums influence asset pricing and returns. Discounted growth essentially represents investor expectations for future economic performance.

Changes in these expectations can significantly impact asset valuations. Additionally, inflation plays a crucial role as it erodes the purchasing power of money over time. Finally, risk premiums reflect the compensation investors demand for taking on greater risk.

A Portfolio Balancing Act: C, EEM, QUAL, BAC, MS

This year's performance highlights the importance of diversification. US equities (C) have lagged behind, while emerging market equities (EEM) have faced headwinds due to a slowdown in global growth. Conversely, bonds (QUAL) and commodities like oil (OIL) have performed better, reflecting investors' flight to safety during uncertain times.

Bank stocks (BAC, MS) have been caught in the crossfire, experiencing volatility as concerns about sovereign debt and economic stability persist.

Navigating Uncertainty: A Cautious Approach for Investors

In light of these trends, investors should adopt a cautious yet balanced approach. Diversification across asset classes remains crucial to mitigate risk. While equities may offer higher potential returns in the long term, they can also be more susceptible to short-term fluctuations.

Bonds and alternative investments can provide stability and diversification benefits during periods of market uncertainty.