There is a traditional acceptance that in the long-term equities outperform bonds which in turn outperform cash.

As with any such statement, it depends on the time period that you are looking at. Over the five years to end October 2001 the MSCI World equity index in US terms has returned some 19% in US$ terms. Over the same period global government bonds, as measured by the SSB Index in US$ terms, has returned 16%. The picture is different over the shorter term with equities losing 9% over 3 years (+1% on bonds), 27% over 2 years (+3% on bonds) and 26% over one year (+9% on bonds).

At this point in time there is a lot of uncertainty regarding the direction of the global economy due, not only to the events on 11th September 2001, but the failure of the Japanese and Euro blocs to provide any balance through an independent economic cycle. Is this one of the consequences of globalisation? To be fair, it was reasonably evident towards the tail end of 2000 and the first quarter of 2001 that a US slowdown, exacerbated by the Nasdaq tech bubble, would result in a weaker economy, lower returns on equities and better returns on bonds.

What has surprised everyone has been the extent of the slowdown, it's global consequences, and whether 4.50% in interest cuts and around US$100bn in fiscal stimulus is going to do the trick. Further smoke and mirror moves by the US Treasury to announce a cessation of 30 year long bond issuance has also distorted the yield curve between 10-30 year.

Against this background, equities have regained their pre-September 11th levels in the US but continue to languish in Europe and especially Japan. Emerging market debt has plunged due to de-facto default in Argentina, and whilst High Yield bonds in the US have managed to weather a spate of bankruptcies, the fledgling Euro high yield market has almost disappeared. Risk aversion has moved to the fore with investors and in this environment, sovereign bonds are in demand. However, as nominal yields move to levels close to those experienced only in Japan over a sustained period, the focus shifts to high-grade corporate bonds where there is safety of principal and higher yields.

On the fixed income side, we have seen an increased willingness by investors to move from a pure government bond benchmark to an aggregate benchmark such as the Lehman global Aggregate. This has the benefits of a higher yield, the inclusion of around 45% in non-government bonds (principally in the US. component) and a lower weighting towards Japan which international investors perceive as an accident waiting to happen.

Given the general expectation of a much hoped for US. recovery next year, although equities may once again be the investment of choice, this will also lead to an improvement in the position of corporate debt which is currently trading at wide differentials to government debt. The scenario could then be one where sovereign bond yields rise but corporate yields remain largely unchanged allowing for an outperformance by aggregate bond indices relative to government bond indices. Even those very conservative clients who are unwilling to change to an aggregate index, are happy to widen their credit guidelines to permit the inclusion of high grade bonds.

Our central expectation for 2002 is for a slow economic recovery with the yield curve remaining fairly steep and inflation continuing to fall. Our favoured positioning would be longer dated government bonds and short/intermediate corporate bonds to deliver a return in excess of pure government bond indicies.