When interest rates approach zero they may transition from historically stimulative to potentially destimulative/regressive influences. Recent central bank behavior, including that of the U.S. Fed, provides assurances that short/intermediate yields will not change, and therefore bond prices are not likely threatened on the downside. Most short to intermediate Treasury yields are dangerously close to the zero-bound which imply limited potential room, if any, for price appreciation. We can't put $100 trillion of credit in a system-wide mattress, but we can move in that direction by delevering.

The broader financial industry is in a state of contraction, and the primary drivers of investment management revenue have become less reliable. Higher volatility and lower returns have fundamentally changed the relationship between investors and the managers to whom they entrust their wealth. We are all being held to a higher standard. We believe those investment management firms that can adapt and absorb these profound changes will come out ahead and will be best prepared to deliver value to their clients.

We are skeptical that fiscal austerity alone is sufficient for all eurozone countries to grow and remain solvent. We thus expect the ECB to continue supporting the euro area with liquidity in 2012. Recent central bank policy in China is oriented toward stabilizing growth in a political succession year, while balancing lingering inflation and medium-term systemic risks. Investors may want to hedge portfolios by looking to select emerging markets with the ability and willingness to cut policy rates both from a cyclical as well as structural perspective.

Many investors remain skeptical, but the market environment for structured products has changed markedly since the financial crisis of 2008. Current pricing now reflects a more realistic view of the underlying fundamentals, including weakness in the global economy and U.S. housing market. We believe now is the time to consider entering the structured credit market.

Treasury Inflation-Protected Securities got a boost last week after the Fed extended the period of time it is likely to maintain unusually easy monetary policy and moved toward adopting a formal inflation target of 2% for the Personal Consumption Expenditure Index. Bernanke said that the central bank was likely to allow deviations from this target if employment was not where the Fed thinks it should be. We think financial repression is likely to persist and real interest rates are likely to be lower than recent history would suggest for the foreseeable future.

Sovereign downgrades will likely be another trigger for cuts in the ratings of European banks. Nearly all major eurozone banks are on negative watch. Even those securities guaranteed by eurozone sovereigns that were not downgraded are also in the ratings agencies crosshairs. The most significant downgrade for benchmark compositions was Portugal -- downgraded to below investment grade by S&P, consistent with Moodys and Fitch.

Because many emerging market high yield companies were able to deleverage after the 2008/2009 crisis, we believe they are generally in a stronger position than their developed market counterparts. Limited financing needs should provide technical support to the overall emerging markets corporate market. In an environment where lending conditions tighten in international capital markets, domestic markets may become a source of funding for EM HY corporates.

We expect emerging Asia growth below the market consensus due to its less aggressive policy responses compared to 2008-2009. The Asia-Pacific region is less affected than others by eurozone turmoil but contagion is still a risk through direct trade and the regional production chains that characterize Asias export-oriented economies. In this environment, we favor Australian government bonds for their high credit quality, low-beta currencies such as the Chinese yuan, corporate issuers that have delevered, covered bonds and mortgage-backed securities.

Even if the euro survives this crisis intact, the market will price in uncertainty as the crisis evolves. Scenario planning is indispensable for investors. Politics may prevent the European Central Bank from buying government bonds, but it could provide funding support via a special government or banking intermediary. This balance sheet expansion could be a negative for the euro. Within the eurozone we believe investors should look at alternatives to the government sector, including agency, regional government and covered bonds.

Italian ILBs now mostly reflect credit risk and tend to trade at a discount to compensate for the higher volatility. Unless the eurozone collectively decides to inflate their way out of their sovereign debt problems through a large increase in the ECB balance sheet, Italian inflation-linked bonds are likely to keep trading like a more volatile and less liquid version of nominal Italian bonds. A European investor looking to secure consumption of real assets in the future may wish to think about alternative measures to help protect their real purchasing power when hedging real liabilities.

Friday's downgrades of European sovereign ratings debt is all over the place-from those dismissing it as old news to those viewing it as part of a larger and consequential transformation of the international monetary system. What follows is an attempt to provide a guide to the multi-faceted implications. It focuses on three types of consequences: 1 those that are unambiguous and already reflected, albeit not fully, in market valuations. 2 those that are less well understood but will become clearer. 3 those that are consequential but where the analytics are still largely unknown at present.

How developed nations address their fiscal deficits will have broad implications for equity markets. Debating a future of inflation vs. deflation is radically new territory for investors. The chaotic nature of the choice facing societies is whipsawing equity markets and dominating bottom-up factors. Equity investors seem to be pricing in a combination of outcomes, with the largest weighting going to a goldilocks, mild inflation scenario. But the markets large daily swings reflect jumps back and forth as investors update the probabilities of very different destinations.

Contrary to finance theory, lower risk appears to produce the potential for higher returns over the long term. Volatility tends to amplify stock returns so higher risk generally leads to higher returns in a positive market and greater losses in a negative market. Over the long run, lower volatility stocks can lead to higher returns because avoiding the downside can have powerful effects on compounding. Higher volatility stocks tend to fit the definition of speculative, while low volatility stocks can offer the potential for preservation of principal and a satisfactory risk-adjusted return.

From 2003 to 2011, over 50% of returns of the MSCI Emerging Markets Index came from country-related and currency-related factors. Over the next 12 months, there will be elections in countries representing just under half of global GDP. Therefore, we expect more policy experimentation, varying degrees of effectiveness, and unintended consequences. Currencies are also an important driver of EM equity returns, and the cost of hedging currencies has meaningfully declined over time.

The New Normal, previously believed to be bell-shaped and thin-tailed in its depiction of growth probability and financial market outcomes, appears to be morphing into a world of fat-tailed, almost bimodal outcomes. A new duality credit and zero-bound interest rate risk, characterizes the financial markets of 2012, offering the fat left-tailed possibility of unforeseen policy delevering or the fat right-tailed possibility of central bank inflationary expansion. Until the outcome becomes clear, investors should consider ways to hedge their bets.

The ECB does not want to be a bridge to an unsustainable and adverse economic destination. They would rather force politicians to address the critical problems of the currency union now. Greece will continue to have an unsustainable debt load until policymakers can come up with a credible plan to generate economic growth. Ultimately, the eurozone countries and many other developed economies have very similar problems: unsustainably rising debt loads coupled with structurally weak and imbalanced growth.

With interest rates so low, many defined benefit plan sponsors have delayed implementing or expanding LDI programs, often using intermediate duration bond portfolios instead. Traditional intermediate duration portfolios may not offer the most attractive yields or the best credit match for pension liabilities, and may make the transition to long-term bonds difficult later. We believe plan sponsors in a waiting mode should consider switching to long duration portfolios with a synthetic overlay in an effort to reduce duration exposure.

The world is playing a game of hot potato with European financial assets, and the European Central Bank is a reluctant player. Together, Europes fiscal and monetary authorities can likely avert a systemic accident, but they must act quickly and courageously. Differentiation among emerging market monetary policies is increasing. And in Australia, the central bank will likely need to ease further in 2012. If every central bank enacts similar monetary policy tools, those tools compete for the same targets (financial and inflation stability), thereby potentially eroding their effectiveness.

The inability to achieve sustainable levels of economic growth raises the risk of recession in many developed world economies. Under financial repression, market interest rates are kept very low for a very long time period with the hope of stimulating investment, but repression also starves savers to the benefit of borrowers. Increasing risk with an uncertain distribution of possible outcomes should lead to caution regarding traditional models and asset allocation practices.

Europe's crisis is morphing again -- for the third time in only 12 months -- and the implications for the global economy are even more complex, unsettling, and troubling.

Fat tails and negative skewness in the distribution curve can arise from the mere possibility of multiple equilibriaeven if both individually appear normal. Once markets arrive at a resting place among different equilibria, they tend to become trapped due to a variety of restraining forces. For all these reasons, we believe that the core building blocks of asset allocation and option pricing in the current macroeconomic environment should allow for the possibility of multimodality. This significantly changes the conceptual approach towards portfolio construction and risk management.

Alpha generation is a distinct component of the strategy because it is critical to actively seek opportunities in all global markets in this challenging environment. Explicit tail risk hedging is essential to prepare for more frequent significant downturns, both to mitigate their effects and to potentially benefit from them. The strategy is positioned to navigate a world of muted growth in the Western economies, significant market volatility, recurring balance sheet issues and continued income and wealth convergence of the emerging world with the developed world.

European leaders still need to do a lot more, and quickly, if they are to catch up and get ahead of the crisis. Accordingly, and regrettably, the specter of volatility caused by European headlines will not recede for long. Investors need to continue to watch and worry about Europe.

Even if global risk deteriorates significantly, emerging markets may continue to offer compelling risk-adjusted return characteristics. Emerging markets external sovereign debt, along with receiving interest rates in higher-quality EM countries, could be the best relative performers. EM currencies would likely sell off sharply in risk-off periods but would also tend to rebound robustly when risk appetite returns. Several Asian currencies are likely to be the best relative performers. Emerging markets assets remain a risk asset class and will not be immune to waves of global jitters.

Since 2009, developed country governments have run fiscal deficits unprecedented outside of wartime, and their debt levels have reached epic heights. Investors accustomed to considering only the interest rate risk associated with their developed government bond holdings have been shocked to find that credit risk has become dominant in many cases. For investors in government bonds, inflation and currency debasement have the potential to be just as costly as outright default. Investors should consider focusing on GDP, or national income, as a measure of a countrys ability to service its debt.

Without a more forceful and coordinated policy response, Europe now faces an increasing risk of a hard landing. In this uncertain environment, volatility will likely remain high, liquidity poor, risk premiums wide and the global economy fragile as financial and credit conditions tighten. Easier monetary policy as well as the potential for more balance sheet support from a larger consortium of global central banks is now needed over our cyclical horizon. If these actions are coordinated and timely, investors and risk takers would be more likely to move off the sidelines.

Even the most sophisticated risk management models can't protect against scenarios we've never even contemplated. In this New Normal economic environment of slow economic growth, high volatility and enormous macro risks we don't believe ignoring major downside risks is prudent for equity investors. We believe investors are best served by employing a combination of three strategies to actively manage downside risk in equity portfolios to hedge against the risks they can see, and equally importantly, the risks they can't see.

One of the many worrying aspects of the European debt crisis, even after more than two years of worsening financial and economic conditions, is that there still appears to be no shared understanding and analysis of the problems facing the monetary union. Therefore, with yet another summit of leaders scheduled for December 9, it is very hard to be confident that European political leaders and the European Central Bank are close to agreeing on a credible and comprehensive plan.

While economic integration has progressed materially since the inception of the EMU, the U.S. scores much higher in terms of labor productivity, labor mobility and wage flexibility. Research shows that wage rigidity-defined as wage freezes or cuts as a fraction of total workers-is much lower in the U.S. than the eurozone. Eliminating these rigidities is crucial for the eurozones growth as an optimum currency area. Albeit painful, the intensity of the debt crisis in Europe may force a quicker progress of reform implementation, which could be a competitive advantage for the EMU in the future.

With the European crisis continuing to dominate the news, many people now realize that todays global economy faces an unusually uncertain outlook. Indeed, Europes turmoil is but one of the multiple global re-alignments in play today. What may be less well recognized is the extent to which specific sectors are already changing in a consequential and permanent manner. This is particularly true for global finance where volatility has increased, liquidity is evaporating, and the role of government is pronounced but inconsistent.

Neither the U.S. economy nor U.S. stock indexes will benefit from the euros decline. A declining euro means a rising dollar in relative terms, so our exports will necessarily become less competitive. During the Great Depression, the country that devalued its currency the quickest and the most was the country that was least affected by depression and that recovered the fastest. This truism will aid Euroland, and hinder the U.S. recovery.

Investors should recognize that Eurolands problems are global and secular in nature; it will be years before Euroland and developed nations in total can constructively escape from their straitjacket of debt. Global growth will likely remain stunted, interest rates artificially low and investors continually disenchanted with returns that fail to match expectations. Investors should consider risk assets in emerging economies, and bonds in the strongest developed economies, where the steep yield curve may offer opportunities for capital gains and potentially higher total returns.

The impact of a major disruption in the supply of oil from Iran would depend on the IEAs intervention, the duration and the degree to which any attack might be a surprise. The market has less cushion than it did earlier this year due to production outages and relatively strong non-OECD demand, leading to sharp draws on inventories. Excess capacity is virtually exhausted and we doubt other OPEC nations would be able to compensate for a reduction in Iranian oil production. In light of these possible price spikes, investors should evaluate how their portfolios might be affected by inflation.

The business sections of this weekend's newspapers understandably focus on last week's disappointing stock market performance (the worst in two months for the S&P) and another round of credit downgrades for European sovereigns (Belgium, Hungary and Portugal). Yet, these are essentially lagging indicators. The stories that may well materialize in the next few weeks will be more heavily influenced by what happens this week to Europe's latest yield curve inversion, core bond rates, and policy announcements.

Can the U.K. economy withstand a further sharp deterioration in the European debt crisis? The prospect of European recession, coupled with the U.K.'s program of tight fiscal policy, points to a challenging economic outlook for the U.K. A weak eurozone means weak export prospects at a time when the U.K. is trying to rebalance its economy towards greater exports. The U.K. economy has made great strides in stabilizing its banking system, but it is not yet in a position where it can withstand a systemic European crisis involving multiple defaults.

Amid great economic stress, policymakers have missed many opportunities to improve the situation and better the lives of people. The leadership void in the U.S. was illustrated by the dismal display of policy dysfunction that led the country to lose its AAA credit rating. European leaders have fared no better. Ben Bernanke and the Fed, however, have demonstrated leadership. What is both remarkable and instructive for the outlook for monetary policy is how active the Fed remains even though it has reached the zero-bound for interest rates.

The removal of government bond supply combined with the likely suppression of yields may encourage investors to seek out greater yield via investment grade bonds in the credit markets. The BoEs new round of QE could exacerbate the imbalance between supply and demand and leave a hole in supply that is highly unlikely to be filled by sterling credit issuance. The lack of issuance in the case of non-financials is generally due to strong corporate balance sheets, undrawn credit lines at banks and the rebirth of the loan market.

Signs of disappointing policy outcomes are, unfortunately, all around us. Over the last two years, American policymakers have failed miserably to lower persistently high unemployment despite a series of stimulus measures, fiscal and monetary, conventional and unconventional. In Europe, the debt crisis has spread despite numerous summits, declarations, policy actions and political changes. In both cases, policymakers identified and sometimes mis-identified the problems and took highly publicized steps to solve them. Yet to no avail. The identified problems not only persisted, they deepened.

Not all hedges have equally increased in value, giving investors the option to reduce the cost of their hedges by considering both direct and indirect hedges. Tail risk hedging may allow certain investors to maintain an allocation to risk assets where they might otherwise deem the position to be too risky and it can also help stabilize portfolios on a mark-to-market basis. Investors may decide to either start implementing hedges now, phase the tail risk strategy in over a period of time, or put the infrastructure in place now and defer implementation until market conditions change.

We believe investment managers can analyze numerous data sources and apply lessons learned from past economic cycles to make assessments about the global economic outlook. These managers can make reasonable judgments about asset classes over the long term and, through rigorous bottom-up research, develop an edge regarding the outlook for individual companies. However, the market is much better at aggregating all the information that could affect any of the thousands of companies in the stock market than any investor could possibly be. Hence predictions are likely to be wrong.

There was a time when America looked down on Japan for the latters inability to deal with its economic problems. No more. Like Japan, America is now realizing how difficult a post bubble economy can be. The fear is that it will also find out that that it lacks some of Japans attributes needed to cope with long years of economic stagnation. The US has no time to waste to build on the important, albeit small progress that has been made in recent weeks. If it does not, there is a risk that the countrys economic fate could end up being even worse than what Japan has experienced.

Growth is the commodity that the world is short of at the moment. Once interest rates inch close to zero and discounted future cash flows are elevated in price, it's difficult to generate much more return if economic growth doesn't follow. Equity markets should be dominated by dividend yields and the return of capital via share buybacks, as opposed to growth. In fixed income assets, we suggest that portfolios should avoid longer dated issues where inflation premiums dominate performance.

Before Nobel laureates Tom Sargent and Chris Sims developed their methods, economists and policymakers had no rigorous way to incorporate expectations into their statistical models. There is a limit to forward guidances effectiveness, which is why the Fed has pursued other policy options since hitting the zero lower bound. An uncanny correlation exists between the Feds preferred measure of the publics long-term inflation expectations and the timing or initial announcement of a quantitative easing or twist program.

China will likely focus more on rebalancing of the investment-focused domestic economy this time, rather than on reflating of the economy to engineer higher growth as it has done in 2008 to 2009. Japans fiscal policy will need to be expansionary to facilitate reconstruction efforts. We believe Australian government bonds have the potential to outperform U.S. Treasuries on a local currency basis, particularly in a left-tail global economic scenario.

Repeated attempts to solve the eurozone's sovereign crisis have failed, reflecting a coordination problem among its fiscal authorities and between the ECB and governments. Markets will not return to supporting the eurozone as it stands, signaling the EMU's leaders to choose one of two solutions: downsize to a smaller, stronger group of countries or adopt a federation with political and fiscal union. A comprehensive solution not only needs the right tools in place, but also requires a credible commitment with regard to sequencing and executing the long-term plan.

The latest volatility has investors asking questions about the securities they own, in particular probing any exposures to European issuers. Cash investors often over-allocate to money market and bank investment vehicles, while the most attractive risk-adjusted opportunities might fall just outside of this space. We currently see opportunities in short-dated, non-financial BBB-rated corporate bonds, along with dollar-hedged bonds and bills issued by sovereigns with solid balance sheets.

?Recent Federal Reserve activity has pushed down the long end of the yield curve, spiking the present value of plan liabilities and widening the funding chasm. The pain of the pension community shows up most obviously in funded status estimates. High and increasing levels of implied equity risk premium in pension plans suggest sponsors expectations are increasingly optimistic about future contributions from risk assets.

For long-term investors, meaning those prepared to stay invested for three, five and even 10 years, who can endure volatility, we believe equities can offer attractive returns. In an extended period of slow economic growth and deleveraging, interest rates are likely to remain low. Actual income generation from investments is important. Hopefully society can institutionalize the lessons from this crisis so that future generations dont repeat it: Individuals, corporations and countries should only borrow to fund long-term investment, not current consumption.?

Markets are in the unusual and very uncomfortable position of being wholly dependent on policymakers and politicians. The investment relevance of company analysis, no matter how good, pales in comparison to the importance of getting the policy calls correct. Faced with this, investors should also remain cautious. Yes there are already opportunities but they will be even more attractive down the road given that the world is now subject to both a synchronized slowdown and de-leveraging.

Long-term profits cannot ultimately grow unless they are partnered with near equal benefits for labor. There is only a New Normal economy at best and a global recession at worst to look forward to in future years. If global policymakers could focus on structural as opposed to cyclical financial solutions, New Normal growth as opposed to recession might be possible.