Bond markets continue to outperform other asset classes in 2014. This confounds the predictions of many asset allocators at the beginning of the year and presents a puzzle. One reason asset allocators were so bearish of bonds was that they believed that central banks would be withdrawing monetary stimulus in 2014 as economies improved, and basically this is what has happened. There is no evidence that the recovery is faltering and the Federal Reserve in the US and the Bank of England in the UK continue to debate when interest rates should start rising. So why are bonds performing so well if monetary stimulus is being withdrawn? The answer to this conundrum lies in Europe. Here, the recovery, which was weak in the first place, is faltering and most of the green shoots are withering. Euroland GDP was €7.91tr in March 2008; it fell to €7.46tr in June 2009 as a result of the Great Recession; climbed to €7.76tr in September 2011 following the initial recovery but then fell back to €7.65tr in March 2013 after the euro crisis. Since then it has crept back to €7.72tr a rise of 0.9%. Inflation is minimal which means that nominal GDP is scarcely growing. Given this scenario, it is little wonder that the yield on 10-year Bunds has fallen below 1%. The problem for the rest of the Eurozone is that their real yields are higher than those in Germany given the yield premiums that investors demand (even after the substantial fall in such premiums since the euro crisis two years ago). These real yields exacerbate the already substantial deflationary forces in Europe. It is instructive to note that the yield curves in Europe have flattened considerably compared to those in the US and the UK, indicating the threat to growth. Mr Draghi talked about the need to loosen fiscal policy at Jackson Hole but it is unlikely that the German authorities who control the purse strings are listening.

Further thoughts on whether the global economy is slowing. To be frank, my position remains the same as it was in April; sit on the fence and wait and see. There is no evidence one way or the other, and with such a lack of clarity it is pointless taking any risks. The continuing surprise is that bonds are still outperforming other asset classes, but whether that is because of a slowing economy or capital outflows from emerging economies remains uncertain. What is certain is the rise in policitical risks, whether it is the Ukraine, Gaza or Iraq. The imposition of sanctions on Russia for its attempts to destabilise the Ukraine is most definitely bad economic news; trade will be reduced and living standards in Russia and also Europe will fall. The other serious concern is the slowdown in the euro economy in the second quarter, particularly in the three major countries. There are possible encouraging signs in Spain, Portugal, Holland but overall the picture is of zero growth and the prospect of deflationLooking at specific data, no clear picture emerges. The global PMI has risen a bit over the last few months and the outlook for emerging economies has improved this year somewhat against expectations, but on the other hand the OECD lead indicator, and the US ECRI index are both pointing to a bit of a slowdown. On balance, we can say downside risks for the global economy has increased a little but the bigger issue is the rise in policital risk.

US economy. Growth in the US was 4% in the 2nd q, more than eradicating the decline of 2.1% in the 1st q, something that looks anomalous. The economy seems to be growing just over 2%; it has been 2.2% over the last 2 and 4 years. Employment growth is about 1 .7%pa meaning that productivity growth is roughly 0.5%pa. This is miserly, well below the 1990s level of 2%pa and as with the UK suggests there is a productivity paradox out there. But on the other hand, the number of jobs out there is increasing at a fairly rapid rate, greater than the rate of population growth and sufficient to reduce the level of unemployment. It all rather suggests that the economy is gradually healing. Consumption is growing at a similar pace, investment at 3.5% and exports at 4.4%. The real drag on the economy has been government consumption which has declined by 1.2%. Trade has been a spur to growth although recently import growth has outstripped exports so reducing that spur. Nominal GDP growth is 4.0%, implying a deflator of 1.8%, and there is little evidence of nominal GDP growth accelerating. This suggest that the Federal Reserve is right to gradually reduce the taper and equally right to being cautious about tightening monetary policy.

Has the Japanese economy turned the corner? The first quarter GDP numbers are encouraging and suggest that not only that the recovery is for real but that deflation is ending. Having grown by 1.5% in 2013, the econonmy grew by 2.8% in the four quarters to March. But what is really significant is that domestic demand grew by 4.6% in that period made up of 2.1% in personal consumption, 0.2% in government consumption and 2.3% in investment spending. In other words, growth in the domestic economy outstripped the ability of the economy to meet that demand and the balance was made up by a surge in imports and a fall in inventories. It is equally encouraging that nominal GDP is also growing, by 0.9% in 2013 and by 2.5% in the four quarters to March. This suggests that the deflator is still negative, i.e. deflation is still present. However, looking at the nominal and real components of domestic demand, there is evidence of substantial inflation of around 3%, with real growth rising by 4% and nominal growth by 7%. This backs up the CPI data where the price level has risen by 2.4% in the year to May (0.1% if food and energy are excluded). With 10 year bond yields at 0.6%, real interest rates in Japan are now very much negative, another precondition for sustained long-term growth. As usual with economics, not everything is rosy; some of the recent monthly data has been downbeat, most noticably the PMI numbers which are back below 50. But the numbers do point to a genuine recovery, helped by the fall in the yen and not only has this benefitted Japan but also its trading partners given the surge in imports.

Is the global economy slowing? As with much in economics, the response is to sit on the fence and wait and see. And the justification for such procrastination is that there is just too much contracdictory evidence. One fascinating developement so far in 2014 has been the outperformance of bonds over equities, something that most pundits did not predict at all. Similarly real yields on index linked bonds have fallen. But the monthly indicators measuring the real economy do not really back this up. The global PMI is 53.5, suggesting decent if not stellar growth, albeit they have weakened slightly since the autumn of last year. The OECD lead indicator rate of growth has also weakened marginally but neither are pointing to a marked slowdown. It is a bit of a mystery. Possible explanations are the weak recovery in OECD investment from the recent cyclical trough and the problems in the emerging economies whose demand for US treasuries remains as high as ever. But as I said, we will have to wait and see and don't sell bonds yet.

Ukraine. The recent events in the Ukraine and more specifically the Crimea have raised global tensions but it is not at all clear what conclusions have been reached and who, if anyone, has won or lost. Let us take Russia first. President Putin has played his hand tolerably skilfully, first threatening confrontation and then withdrawing that threat but leaving a clear signal that Russia has vital interests that must not be ignored by the West. Russia has probably won this battle but otherwise is struggling. There is little doubt that the latest upheaval in Kiev has gone against Russian interests and the majority of Ukrainians have clearly shown that they do not want to be part of a Russian sphere of influence, no matter how close the two peoples are culturally. Even the Russian speakers in the east of the country have not shown much enthusiasm for Russia itself, certainly not in the way that those in the Crimea have. Secondly, the Russian economy is seriously underperforming despite its energy riches and capital and people continue to leave. The population is rapidly shrinking thanks to a low birth rate and high death rate, not helped by high incidences of alcoholism and AIDS. Thirdly, Putin has used Europe’s dependence on Russian gas supplies as a lever to get his way in the Crimea but in the long run that will encourage Europe to seek other sources of supply. As regards the Ukraine itself, the Crimea is a side issue. Certainly, Russian belligerence has demonstrated how weak the Ukraine is but that was common knowledge. The Crimea only became part of the Ukraine in 1954 thanks to some shenanigans by Khrushchev and there are no real cultural or historical connections between the two regions. What is crucial for the Ukraine is to get its economy sorted out with help from the West and to keep the Russian part of the country and its oligarchs onside. This will not be easy and the historical precedents do not fill one with confidence. The Crimean crisis has shown the West to be rather weak in the face of Russian belligerence. It has not done President Obama any favours, with the conclusion being that he has been outsmarted by Putin yet again following on from the Syrian chemical weapons fiasco. But the Crimea was not a war worth fighting and talk of sanctions against Russian businessmen seems wide of the mark given that the West wants to encourage Russian capital to continue leaving the country. The key interest for the West as mentioned above is to get the Ukraine economy out of trouble through a generous aid package, and if the Ukraine cannot deliver its side of the package by implanting the necessary reforms, then maybe the conclusion is Russia is welcome to the country. Ultimately, the West has to negotiate with Russia; if Russian wants the Crimea and the Crimeans want to be Russian, then so be it. That is a small price to pay for bringing the Ukraine into the West’s sphere of influence and simply demonstrates just how weak Russia really is.

The UK authorities are in danger of getting themselves in a mess over when the first rate rise should be. The Governor of the Bank of England somewhat rashly suggested that this could be when unemployment falls below 7%. Now that employment is at 7.1%, one could reach the conclusion that a rate rise is imminent. Not so says the Governor; 7% was only an indicator and the rate rise is still a long way off. The result is that everyone is confused and really none the wiser, which was not the intention of the Bank of England. What should determine when the first rate rise occurs? Unemployment is certainly one possible indicator and the level has fallen from a peak of 8.4% just over a year ago to 7.1% now. But the employment market has been behaving somewhat strangely recently with a large fall in productivity as employers have squeezed wages rather than employment. This rather suggests that rising output could easily be produced by the existing labour force without introducing any stress into the system. The second indicator is inflation and here the evidence is that inflation is falling rather than rising. Indeed, many commentators are worried about the threat of deflation, and are urging the authorities to maintain an easy money policy for much longer. Neither employment nor inflation supports the case for a rate rise. There is a third indicator that possibly does and this is nominal GDP. This is not quite the same as targeting nominal GDP which some commentators support but it is along the same lines. Before the financial crisis, UK nominal GDP grew at an average rate of around 5% (2.5% real growth and 2.5% inflation very roughly). UK nominal GDP is currently growing at 3%pa and accelerating. Whether or not it goes through 5% is anyone’s guess and it may be that the current recovery will fizzle out particularly if the BoE increase rates prematurely. The possibility of derailing a nascent recovery is a very real risk and one that the Japanese were quite good at doing in the 90s and 00s. Low and falling inflation is probably telling us that there is plenty of spare capacity, albeit the rapidly falling unemployment rate is suggesting something rather different. The BoE does not have an easy task and no-one will blame it for doing nothing at the moment. Wait and see is the correct policy response. But the indicator to watch is nominal GDP, particularly after the very strong preliminary 4/Q GDP estimate. Do not be distracted by over emphasis on the inflation rate. By way of contrast is the situation in Europe, where there is a very real risk of deflation and emphasis on the core inflation rate is very much justified. The latest reported core inflation figure is 0.7% and falling. Nominal GDP growth is minimal. There is evidence of quite a strong bounce in activity but from a very low base. There is very little evidence that Europe will catch up what it has lost in relative terms over the last two years. The exchange rate is too high and the ECB needs to be much more active in stimulating activity. It remains too complacent.