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Global equity markets have almost exactly doubled since the darkest days of early 2009. Even subprime bonds, the culprit for the greatest economic crash in living memory, have enjoyed spectacular gains. All this has come against a gloomy backdrop of high unemployment, record levels of government debt and emergency action by many central banks. Why has this happened, and can it continue?

In retrospect, the reason for this dramatic recovery in asset prices is straightforward. The emergency action taken by policy makers has “worked,” if only in the narrow sense that it has stopped the economic situation from getting worse. In the darkest hours of 2009, many financial assets were priced at levels consistent not just with the worst recession since World War II, but with a repeat of the outright depression seen in the 1930s. This has now been avoided, and markets have breathed a sigh of relief.

Investment managers sometimes remark that “the easy gains for the current cycle have already been made.” The behavior of markets always seems much easier to interpret in retrospect than it does in real time. But there is some truth in this statement on this occasion. As it became clear that the rescue operation was restoring confidence to the financial sector, the pricing of risk assets proved far too depressed to persist. But that is no longer the case. One popular benchmark measure of value in global stock markets is the price-earnings ratio on US equities. Based on American economist Robert Shiller’s method, this now stands at 23.8, compared to its long-term average of 16.4. In other words, American shares are now somewhat expensive compared to their long-term history. In order to justify these ratings, the global economy must continue to grow quite rapidly.

Fortunately, that seems probable. The world economy is improving for two main reasons. First, in the emerging economies there was no credit crunch, banking collapse or explosion of public debt. These fast-growing markets, which now account for 47 percent of the world’s gross domestic product, were barely dented and have quickly resumed their extraordinary growth of the previous decade.

Some still see this as a bubble waiting to burst. It is much more likely that we are in the midst of the most extraordinary surge of economic growth since the Industrial Revolution. The emerging world now has better debt ratios and stronger balance sheets than the developed world. That does not mean emerging nations are automatically the right places to invest since their equity markets now look fairly expensive. But it does mean a strong source of growth in global demand will remain in place.

The second reason for recovery may prove less robust. This is the gradual normalization of business and consumer behavior which is under way in the United States and much of Europe. Across the developed world, the shock experienced by the private sector in 2008 was so great that people and businesses took quite extraordinary measures to postpone nonessential spending and to avoid long-term commitments. As a result, they raised their savings rates and began to pay down their debt. Such was the collapse in the private sector’s spending relative to its income that balance sheets had already started to improve by spring 2009. Since then, the private sector has relaxed a little, continuing to pay down debt, but not quite as much as before. With some money left over to allocate to consumer spending and capital investment, economies have started to grow again.

In the aftermath of some earlier crises — for example, those in Scandinavia and Britain in the mid-1990s — economies have improved for many years as this healing process has continued. In other cases, such as Japan, they have become mired in a deflationary trap from which they have never really emerged. Still others, such as the United States in the 1930s, enjoyed a strong early recovery, which led policy makers to tighten fiscal and monetary policy too rapidly, choking off growth before unemployment could return to normal. The premature tightening of macroeconomic policy in the United States in 1937 still haunts American policy makers. And if it doesn’t, it should. Then, it took the rearmament program of the early 1940s to end the Depression.

The future for asset prices will be determined by which of these templates is followed. Will the healing process remain on track? Or will Japanese-style deflation take hold? Will policy makers tighten too soon, as in the 1930s? Or, worst of all, will they tighten too late, leading to a fiscal crisis or rapidly rising inflation — the endgame after many earlier episodes when government debt has ballooned. This represents an alarming list of very different outcomes, with no clear lessons from history to rely upon.

In the first of these scenarios, investors should prefer equities and commodities to bonds. In the second and third, they should prefer government bonds to any form of risky assets, housing included. And in the final inflationary scenario, there will be no hiding place, except possibly index-linked bonds and some commodities such as gold.

I am cautiously optimistic about the outcome. Central banks can keep policy easy to aid recovery, and so far they have been ready to do this. Capitalism did not (quite) meet its maker in 2008. There is life in the old dog yet.

Gavyn Davies is co-founder of Fulcrum Asset Management and Prisma Capital Partners, and a former chief economist of Goldman Sachs.

Prospect Magazine