Dividend yield provides downside support.  Cyclical growth and earnings risks remain, but we think yield support beyond the risk-free rate joins a growing list of valuation measures that help limit downside risk to equities and suggests that earnings risks are already heavily discounted - a positive for the near term. We have run some screens to highlight stocks that look attractive on a yield basis. We apply some filters to raise conviction levels in the sustainability of current dividends.  

Shifting to new tactics: We got our rates call wrong this year and missed a great opportunity to be long.  The market is currently rife with relative-value opportunities, and that's what we will focus on going forward.  Previously, we did not give enough weight to a scenario of sub-2% growth in 2H10, a threshold that, if reached, we think could generate a deflation scare that might bring the US Treasury 10-year into the 2.00-2.25% range.  

Prospect of a range-bound equity market in the coming years should increase investor focus on dividends, and we have updated two strategic tools to identify stocks with a particularly attractive yield proposition.  The first is the ‘equity carry' list, which details companies whose dividend yield is greater than the implied credit yield.  The second is our list of stocks that our analysts believe offer investors a high and secure dividend yield. 

Some encouraging credit trends support pushing back on pervasive growth concerns.  It's early days, for sure, but we believe the combination of a revival in funding markets outside of corporate bonds and the current rebound in M&A from the bottom are helping to support our constructive secular view on credit, as managements markedly withdrew from both these financing and strategic avenues during the recession. 

Two debates are dominating the August market lull:  1) Are US Treasuries in a bubble? 2) Will M&A take off?  To many, these debates are two sides of the conflicting signals coming from the debt market (double dip and deflation) and the equity market (sustainable growth).  However, it is investors seeking yield in uncertain markets that connects these two debates.  Somewhat paradoxically, this should offer continued support for risky assets. 

We believe there are attractive opportunities to monetize volatility to earn yield today in equities, owing to a variety of fundamental and market factors.  The recent rally in the long end of the Treasury market has had significant implications for the quest to earn yield throughout both fixed income and equities.  However, despite the rally in rates, Treasury curves remain steep by most historical measures, and we see a similar theme in the equity volatility world as well. 

EM equities have recently begun to outperform significantly, after range-trading against DM equities in H1 2010. A number of catalysts are falling into place for EM equities. These include: a) EM's superior economic and earnings growth outlook, b) the peaking of inflation in Asia and hence resolution of policy uncertainty, c) China's CNY de-peg decision, d) the resilience of commodity prices, and e) superior fund inflows to EM equity funds versus DM equity funds.   

Australia's debt-fueled housing market remains a major macro risk.  Dodging the worst of the global financial crisis didn't demonstrate that there's no bubble, in my view, it just showed we dodged the prick that ended it.  I'm not persuaded by arguments that houses are sustainably priced; that debt is not a problem; or that policymakers can prevent collateral damage to banks.  But risk of big price declines in the near term seems low.   

Debt/GDP ratios underestimate the fiscal challenge faced by advanced economies.  Based on current policies, most governments are deep in negative equity, which means they will impose a loss on some of their stakeholders, in our view.  The question is which promises they will renege upon, and what form this will take.  An alternative to outright default is "financial oppression" - imposing on creditors real rates of return that are either negative or artificially low.

Less risk to the outlook from consumer deleveraging.  American consumers have deleveraged their balance sheets and rebuilt saving faster than expected.  While debt-to-income ratios and other measures of leverage are still elevated, household debt service is lower and saving higher than expected in relation to income.  Consequently, in our view, the headwind to consumer spending from deleveraging is now a smaller risk to the outlook.  

We stick to our view of growth moderation for the global economy in 2H10 and 2011, not a double-dip.  The ‘AAA' (ample, abundant, augmenting) liquidity regime maintained by deflation-averse central banks in developed markets is spilling over into emerging markets through lower global bond yields and capital inflows.  This should allow EM central banks to continue to withdraw some domestic monetary support without risking a sharp deceleration of their economies. 

In one global debate, many think the US will follow Japan into deflation.  We do not.  Why?  Japan turned a financial recession into a secular deflation due to (a) strong independence of the central bank with low accountability, and (b) an election that skewed seat distribution in favor of older voters.  Neither the US nor Europe shares these institutional problems.  When markets understand the institutional differences better, the deflation scare should fade.

Raising our German forecasts:  A stronger-than-expected 2Q GDP and revisions to past data cause us to raise our 2010 GDP forecast for Germany from an already bullish 2.5% to a bumper 3.4%.  And we still forecast Germany to maintain an above-trend growth rate of 1.7% next year. However, we expect a number of activity indicators to show signs of peaking out. The upward revision to our German forecasts introduces upside risks to the euro area - a welcome cushion. 

Korea is becoming less vulnerable to external financial shocks on the back of an improving credit position.  Korea has been repaying its external debt since 2008, and the government has introduced measures to regulate banks' short-term external borrowings to minimize currency fluctuations due to large capital flows.  Korea has returned to its status as a net external creditor, rather than a debtor, as it was in 2008.

For Mexico, concerns about a potential broad US relapse seem justified.  Mexico is posting some of the strongest growth figures so far in the cycle, but concerns are mounting about the strength and sustainability of the recovery in the US.  With the industrial sectors in both economies as synchronized as ever, the outlook for Mexico depends heavily on continuous support from a strong US manufacturing sector.  

Cyclical tailwinds helped Thailand's economy grow 9.1% in 2Q10, beating 8% estimates (ours and the consensus).  But we still expect growth to decelerate in 2H10 and 2011 as the base effects diminish.  Realization of Thailand‘s full growth potential in the medium term still calls for the domestic demand cylinder to be firing, which would require sustainable politics to get capex, consumer spending and public expenditure continuity under way.  

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