Back in January we highlighted a balanced portfolio approach to looking at the boom and bust cycle of asset prices. As you can see in the diagram below, as money flows to the right – out of low yielding money and into higher yielding bonds and capital investments – it pushes asset prices higher and forces yields lower. This is the boom phase of the cycle because the rise in asset prices produces capital gains and the wealth effect spurs consumption and investment.

The bust phase of the cycle occurs when central banks raise interest rates. This increases the yield on money which in turn slows the boom phase of the cycle. The risk-adjusted yield on money rises higher than the yield on less liquid and riskier assets. Capital flows to the left – fleeing overvalued bonds and risky capital investments in real assets like land, labour and capital investment projects. This phase of the cycle is characterised by a rush for liquidity and by financial distress.

We have seen a glimpse of both the boom and bust phase of the cycle so far in 2006. The boom phase of the global economy encouraged rising yields on money and bonds as central banks continued with a global tightening cycle. Expected returns from riskier and less liquid investments, in private equity or commodities for example, have attracted capital from lower yielding bonds – sustaining the boom phase of the cycle. Bond yields and yields on money have risen in 2006 to maintain portfolio balance with the higher expected yield from riskier capital assets.

Central banks have become concerned that policy rates are too low and they fear an unmitigated boom in asset price inflation. Copper and gold prices going vertical (see chart) certainly caught the attention of central banks and suggested easy monetary policies on a global level.

The rise in financial market volatility is a glimmer of capital flowing towards the bust phase of the cycle, i.e. capital is flowing to the left in the portfolio balance diagram. The rise in yield on money and rise in bond yields in spring 2006 have started to look more competitive on a risk-adjusted basis to investors in risky assets such as emerging market equities and bonds.

Aversion to risk hit emerging markets particularly hard. Riskaverse investors are going through a phase where they perceive risk-adjusted yields on emerging market assets as too low and they have fled to the safety and liquidity of cash and risk-free bonds. This process has lowered the price of emerging market assets but is also raising their yields.

So, is this the start of the bust phase of the cycle? We doubt it. There is no doubt that some asset prices have swung to overvalued levels and yields on cash and risk-free bonds look attractive by comparison. Nevertheless, we still think that global policy rates are accommodative and the level of interest rates on bonds is not going to seriously impede economic growth.

We anticipated the rise in volatility but view the financial tremors as buying opportunities as long as our analysts see value in the assets. We highlighted in our January outlook that there would be some hand-wringing over the direction of the economic cycle and the sustainability of asset prices. We suggested then that it would pay investors to recognise the primary trend on the flow of liquidity. The global economy is still awash in liquidity, although central banks are attempting to soak some of it up by raising the yield on money.

We believe that capital will continue to flow to the right in the portfolio balance diagram. Here are a few examples of the liquidity that is still available: investment banks are announcing record profits and will certainly put those profits to work by raising leverage in their trading and underwriting operations and filling demand by creating new securities. In addition, private equity and venture capital funds are closing the books on billion dollar deals and will need to put the assets into less liquid and risky assets. Furthermore, corporate profits are very strong with lots of cash on balance sheets and shareholders are encouraging management to take more risk or return cash to shareholders via stock buy-backs or raising dividends. Increased merger and acquisition activity and leveraged buyouts are classic signs of greater risk tolerance. Finally, the level of real global policy rates is not that restrictive.

Our conclusion is that there is still ample liquidity to flow into risky assets. When liquidity flows to the right in the portfolio balance diagram, it raises asset prices and sustains demand. A major risk would be an inflation breakout, particularly in the US, but unit labour costs are very low in the US and around the world. The high growth, high productivity and low inflation global expansion is good for asset prices as long as central banks do not choke it off by raising the yield on money too far, which seems unlikely at this point. Busts follow booms but there still seems more liquidity to flow towards the boom phase of the cycle before the risk of a bust phase increases dramatically.