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 So why are bonds performing so well if monetary stimulus is being withdrawn?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.