Editor’s note: Among the examples of the economic and market commentary this publication receives, here is an interesting account of recent events and their implications from Chris Iggo, chief investment officer, fixed income,at  AXA IM. As ever, this publication does not necessarily endorse the views contained in this article.

First of all, welcome back to all of my readers that had the opportunity to take some time off during the summer. Given the dire state of the financial markets at the end of August I think most would have preferred to be on vacation rather than in the office. I was in the Caribbean where a local taxi driver explained to me his view of the global economic situation and how it affected the islands – “It’s a trickle down effect man. But you just need to chill out.” Fine advice indeed.

Trouble is, it’s not easy to chill out at the moment. Things do look quite bleak. Let’s take the macro environment. Most forecasters have downgraded their gross domestic product growth outlook for this year and 2012. Markets have taken a dimmer view than economists, pricing in a double-dip recession. Last month the Fed signalled that it would keep official rates close to zero for the next two years, implicitly signalling that it expects weak growth for the foreseeable future. Bond yields fell massively in August with 5-year government bond yields in the US, UK and Germany getting as low as 0.8 per cent, 1.1 per cent and 1.15 per cent respectively. These are not quite Japan levels yet but we are almost three years into the Fed’s zero interest rate policy, which is making the Japanese comparison a little bit more credible than many – including myself – ever thought was possible.

At the centre of the recent bout of risk aversion is a lack of confidence in the ability of the global economy to deal with debt. Expectations of growth have been revised down, which means either that debt to GDP levels will remain high for longer or more severe austerity. Moreover, the confidence of investors in the ability of policy makers to accelerate the adjustment has all but disappeared. It is hard to see the situation in the eurozone improving enough to allow investors to become less worried about contagion and widespread default.

At the moment, despite numerous attempts, there is no convincing structural solution to the debt crisis and few observers believe that the political willingness to move swiftly to more centralised and integrated fiscal policy within Europe is there. What we do have is a series of ad hoc “sticking plasters” – the ECB buying of peripheral debt, “troika” financing schemes for the most indebted, blueprints for the strengthening of the EFSF and vague promises of national budget deficit ceilings – but the aggregation of all these is still not enough to convince investors that debt dynamics will start to move in a positive direction any time soon. In the US the debt ceiling agreement fooled no-one a year ahead of a general election. The US has been lucky that things are worse elsewhere so Treasury bonds have retained a strong safe haven attraction, but I suspect that the fiscal fissures will be highlighted again in 2012 as voters and investors study the plans of the Democratic and Republican candidates for the White House.

Debt is an inter-temporal transfer of consumption. The debtor is able to boost consumption today at the expense of consumption in the future. However, this can be a rational decision if the debtor expects income to rise in the future and therefore consumption is smoothed over time. The creditor gives up consumption today in order to generate income to finance consumption in the future. The creditor also wants growth in the debtor’s income such that the risk of the debtor being able to repay is minimised. Of course, this “life-cycle” explanation of debt falls apart when either debt levels or financing costs get too high or when future income is lower than expected. Many countries are facing different combinations of these problems (Greece, Portugal and Ireland all three!). The most worrying is the lack of growth.

In hindsight the credit boom perpetuated itself, as all great bubbles do. Building higher levels of debt rests on the assumption that growth will be sufficiently strong to allow it to be managed easily in the future. The creation of the debt itself appeared to boost growth. We bought higher levels of GDP growth in the last couple of decades and the illusion of the “new paradigm” just made people and governments more eager to borrow. And now we are in the great balance sheet adjustment.

So growth is weak and will remain weak. Or perhaps growth is more in line with the real underlying potential of ageing, productivity-constrained Western economies. Maybe 2 per cent GDP growth is the new norm. There certainly doesn’t seem to be much that policy makers can do to offset either the drag from balance sheet adjustment or the natural slowing of the underlying GDP growth rate. That means market expectations have to be neutralised on a scenario of weak growth – meaning low interest rates and bond yields and much more realistic (lower) earnings growth expectations in equity markets. This is not necessarily a bad scenario for corporate and high yield bonds though.

As long as there is some growth but companies manage their balance sheets in a conservative way, there is no reason why defaults should increase. That’s why I think the recent sell-off in credit is overdone and makes some parts of the bond market look very attractive now. Credit provides a yield that is positive in real terms and some opportunity for capital appreciation.

A weak growth outlook makes all debtors more vulnerable. Of course, not all debtors are the same and the slowdown in growth has been accompanied by a growing dispersion of credit risks amongst sovereign and non-sovereign borrowers. Weaker growth used to mean lower yields in the good old days when the world was all about interest rates. But today, weaker growth means higher credit spreads for the most indebted sovereigns and ludicrously low yields for the best borrowers. And while yields and spreads have risen and are looking attractive at face value, it is hard to justify aggressively buying these assets until there is more clarity on the growth outlook.

I remain of the belief that part of the longer term solution to dealing with debt will be higher inflation. Central banks are pledging to keep real interest rates below zero and maybe to do more quantitative easing. Might we even see more explicit monetisation of government borrowing in the future? Certainly if the Fed wants to reflate the US economy even more then there will be downward pressure on the dollar and this will lead to another wave of attempts to keep the value of emerging market currencies competitive, a policy response that is inflationary.

I have never really understood gold bugs but I think there is a clear message from the meteoric rise in gold prices this year and that is that the value of paper money is being eroded by unconventional monetary policy. The dollar is not so far away from its all-time lows (on a trade weighted basis) reached in 2008 and it could very well fall below those lows if the Fed does announce another round of QE. Inflation is at levels that are close to the historical average…at least this is one difference with Japan, inflation in western economies is still positive and rising.

In addition to inflation we need real growth. That is what we are struggling to see right now. However, I would suggest that sentiment has turned so negative that, in the short term, there is scope for positive surprises. We are in a low growth period, not in a recession. And I don’t think a double-dip is really likely – at least nothing worse than a shallow technical version. We will see. The US ISM for August came in at 50.6, so suggesting flat growth with some inflation (prices paid at 55). The headline number was slightly above market expectations.

If there are some upside surprises – and I guess they will only be modest – then being long credit and high yield in the bond market will be the most rewarding trade. Low growth without a downturn with companies that are cash rich is a positive credit environment. Short duration in rates is probably the best risk-adjusted position but yields on the risk free curve are not going to rise much when central banks are committed to super easy policy for some time and when inflation has been eradicated from most policy-makers forecasts. For longer-term institutional investors the argument to have index-linked rather than nominal bonds is stronger than ever.

One corporate and sporting success story is, of course, Manchester United. The team has started the season very well and the club just announced record profits. There was no need to panic on the last day of the transfer window last week. Debt can, in some cases, deliver the goods.