In A Christmas Carol, Charles Dickens describes his most famous character as follows: “External heat and cold had little influence on Scrooge. No warmth could warm, no wintry weather chill him. No wind that blew was bitterer than he, no falling snow was more intent upon its purpose, no pelting rain less open to entreaty.” Over the past five months investors have been acting in a Scrooge-like fashion as neither rate cuts, promises of fiscal stimulus nor unprecedented support for the banking system improved their mood. They continued to sell cross-border equities.

This wave of selling turned into a tsunami in October. In the weeks following the bankruptcy of Lehman Brothers what had looked like measured reduction in risk appetite in response to worsening economic news became a full-scale rout in equity markets. State Street Global Markets’ regime map flipped into riot point, the most bearish regime. However, as the year draws to a close it does so on a more optimistic note. The current regime is leverage.

The regime map is a pictorial representation of monthly cross-border equity flows. Each cluster on the map represents a different pattern of flows. The seeds of any recovery in sentiment were always likely to be sown during a panicked capitulation. But institutional investors are still feeling a little shell-shocked. The resurgence of flows is highly selective, mainly focused on emerging markets, especially Latin America. Though the overall picture remains quite bleak, the wholesale repatriation seen in October has slowed and in places reversed.

A pick up in emerging market flows in the early part of 2008 did foreshadow a broader recovery in equity investing. Emerging markets rallied and developed markets traded sideways. Considering what was to follow that sort of environment would be a wonderful Christmas present for investors.

The signs of a nascent recovery in risk appetite are also evident in other markets. Flows are correlating with real effective exchange rates (a measure of value) in the FX market and investors are buying currencies such as the Korean won and Kiwi dollar. These two currencies are respectively down 33% and 23% against the dollar year-to-date.

Bargain hunting may also form part of the explanation for the trickling back of equity capital. The MSCI World index is down 46% year-to-date, but emerging markets have fallen further still with the MSCI Emerging Markets index recording a 60% decline.

However, the shift in sentiment is also consistent with the degree and extent of the policy response from central banks and governments. Riot point is the least persistent of the five regimes partly because the aggressive selling of equities generally points to a broader economic malaise. This forces policymakers into action and the riot subsides.

The degree of the policy response in the past six weeks has been remarkable. Markets expect UK rates to head to 1.5% in 2009 and the European Central Bank to cut to 2%. It was only six months since the ECB increased interest rates. Yet, even as central banks play catch-up with the Federal Reserve, it has now embarked on quantitative easing designed to loosen monetary policy still further. The printing presses have been fired up and president-elect Obama looks set to announce a New Deal-style stimulus package encompassing massive investment in America’s fraying infrastructure.

Whether these unprecedented steps are enough to stop a cyclical downturn from turning into a slump remains to be seen. This huge uncertainty concerning the depth of the coming recession makes forecasting future earnings - always an art performed by wannabe scientists - all but impossible. Positive consensus earnings forecasts for 2009 seem completely unhinged from reality. In this environment the signal from flows is even more valuable.

This is particularly true so long as there continues to be discussion of deflation. US TIPS (Treasury Inflation-Protected Securities) are already pricing in deflation in 2009. A deflationary backdrop would render current prognostications about what represents fair value for equity markets obsolete. Earnings would fall further than all bar the most bearish forecasts are currently expecting and so would prices to compensate.

If deflation does get baked into expectations it will be hard for there to be a sustained rally. However, policymakers are all too familiar with what unfolded in Japan in the 1990s when a debt deflation cycle took hold. They will do everything in their power to stop it. A deflationary bust will probably prove as illusory as the Weimar-style hyperinflation some were forecasting when oil briefly touched $149 a barrel last summer. 

As economic forecasts turn from dire to disastrous, it would be tempting to emit a Scrooge-like cry of “bah humbug” to the prospects for a prosperous 2009. However, even in the midst of winter there are signs that investor sentiment is thawing. There are many possible explanations.

Equity valuations are cheap in most scenarios other than outright deflation and safe haven assets, especially government bonds, are deeply unattractive unless we really are on the brink of an economic disaster.

The merest hint of positive news to support tentative buying could see a sharp snap-back for risky assets.

Michael Metcalfe is global head of macro strategy at State Street Global Markets