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In July last year the Dow Jones Industrial Average hit what was then an all time high, closing above 14,000 for the first time. All seemed set fair. Banks were announcing record results, house prices moved inexorably upwards and the former CEO of Citigroup was still cutting a rug. In the first week of the month 60-day flows into developed markets as tracked by State Street Global Markets' Cross-border Equity Flow Indicator, were close to a record in the ninety-ninth percentile (flows only higher on 1% of previous occasions in the 11-year history of the measure). Bankers departing for the beaches in August could do so with a clear conscience.

Unfortunately, their Blackberries then went into meltdown as the credit crunch unfolded. With summer upon us once again, what chance is there that this holiday season will prove more relaxing? The message from flows is a positive one. They have recovered to their healthiest level since the golden days of July 2007. Three month developed market flows are now in the eighty-third percentile and the momentum of flows is also positive (much more so than in July last year when emerging market flows slumped, signaling trouble ahead). One-month flows into developed markets have hit the ninety-eighth percentile.

This remarkable recovery in risk appetite is also reflected in the regime map. The map is a graphical representation of the pattern of cross-border equity flows. It is used by the strategy teams at State Street Global Markets across asset classes to characterise investor behaviour and its interaction with asset prices. At the start of the year the regime map had spent four months in riot point, the most risk averse of the five regimes. Back then, monthly flows into developed markets languished in the second percentile (higher on 98% of other one month time periods).

The current regime remains at leverage for the fourth month. Though investors moved early, their more bullish stance has been vindicated by the markets. The MSCI World index is now up more than 13% from its lows, credit spreads have narrowed sharply and yields on government bonds have increased. The flight-to-safety behaviour during the bleak mid-winter has reversed. Like the weather, the outlook is brighter. During this period, flows have broadened, from the selective buying of commodity producing emerging markets to a more generally positive tenor.

This new-found confidence is also reflected by the sector preferences of equity buyers. Selling of defensive sectors such as consumer staples has intensified over the last four months. The correlation between flows and market beta has also turned positive for the first time since the start of the credit crisis. Beta measures whether a stock moves in line with the market, and the fact investors are buying beta is a good indication of bullishness.

The fear is that this will prove a false dawn and we are witnessing a classic bear market rally. So far, institutional investors have been prepared to look through mixed economic data in the expectation of better times ahead. The key question now is: what will be the second order effects of the credit crisis on the real economy? What is clear is that the credit crunch is no longer just a phenomenon of markets. The April bank lending survey from the European Central Bank confirmed what its counterpart US report had already indicated. It spoke of a "further increase …in banks' net tightening of credit standards".

Those consumers most reliant on credit in those markets with the most inflated property valuations are vulnerable, with the UK, Spain and Ireland to the fore. Spanish GDP grew at its lowest rate in a decade in the first quarter. However, the core of the euro-zone is proving much more vital than the periphery. German GDP in the first quarter grew at 1.5%, the best expansion since 1996 and more than double the rate of growth of the US.

That will give some hope to those that believe that global growth can decouple from a slowing US and provide more fuel for the rally in stock markets. Leverage is the most stable of the five regimes of the map. Looking at past history there is a 72% chance that it will remain in leverage next month. After the bursting of the TMT bubble and short-lived US recession in 2001-2002, the map stayed in the leverage regime for eleven months between May 2003 and March 2004.

However, even the most bullish investor would find it difficult to argue we are at an equivalent point in the economic cycle now. May 2003 was some 27 months after the onset of the previous recession. There are many potential economic snares and pitfalls that could yet derail risk appetite in the months ahead. Those of us in the financial services industry will at least be hoping for a quiet holiday season.

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