There is ample evidence that the main risk is to underweight equities at a time equities outperform. Outperformance of equities over bonds typically occurs in short and sharp moves. To address that risk it is important to combine insights from a bottom-up country perspective with a broad top-down asset allocation perspective. By doing so, we can use country allocation decisions to hedge part of the risk of our asset allocation decisions.

At present we are bullish on bonds and have an underweight position in equities. We arrive at that conclusion using scenarios. We will briefly describe the consequences of three scenarios.

Inflation is not considered an issue at the moment. When inflation should unexpectedly rise in the US (this is a low probability alternative scenario) we would consider this mainly a negative for US bonds and, to a lesser extent, US equities. European assets should do better than US equities and bonds in that environment, although there is a risk of contagion. Japanese equities are less susceptible to contagion by an inflation-induced correction in the US, which is why Japanese equities should be overweighed in that scenario.

In our central scenario economic growth in the US will fall back to more sustainable levels. This scenario mild continuation of the Asian shock" implies that current real rates in the US are very high. US bonds look attractive, while the ability for US equities to outperform is limited. This is because we have reason to believe that the risk of downward earnings revisions in the US is very real. European equities are expected to do relatively well in our central scenario, given the potential for further earnings growth by restructuring. European bonds still look attractive.

If this falling economic growth in the US is combined with falling inflation caused by lack of pricing power we get a picture that is obviously positive for US bonds, but negative for US equities. This is our deflation scenario. Japanese equities especially would be hurt by a slowdown in the US, while European equities should outperform in a global equity portfolio. European bonds are an attractive investment in this scenario.


q US and European bonds outperform in two out of three scenarios

q Japanese bonds are not attractive in any scenario

q European equities should do reasonably well in every scenario

q US equities have limited room to outperform

q Japanese equities can diversify the risk of contagion

q A balanced bet would be to overweight bonds and compensate the risk of US inflation with an underweight position in US equities and an overweight position in European.

René Veerman and Thijs Jochems are with Achmea Asset Management in Appledorn"