Could it be that equity and bond investors are living in the best of all worlds at the moment?

Tim Bond, head of global asset allocation at Barclays Capital, has hinted that they might be. He says that history shows current conditions to be the best for both assets.

 Since 1925, we find that in those years in which GDP was above trend and inflation below trend, U.S. equities have delivered an average 10.6 percent real return, with 20-year Treasuries delivering a 5.2 percent real return. 

But this is not the number one scenario for either.

This is the second best return regime of the business cycle, beaten only by those periods in which both growth and inflation are below trend, the condition that has applied so far
this year.

Specifically, the findings were as follows:

         Real annual returns, 1925-2008, U.S. assets
                                       Real annual returns Pct
                                                                             Equities Bonds Tbills

                Low GDP, Low CPI                                   11.4    10.1    2.8
                High GDP, Low CPI                                  10.6     5.2     1.3
                High GDP, High CPI                                  8.2     -1.2    -0.9           
                Low GDP, High CPI                                  -1.9     -5.0    -1.7

      The highs and lows are calculated based on trends over time with Bond estimating that current U.S. trend growth is about 2.3 percent and trend inflation 2.3 percent.

Reuters polls project the U.S. economy to contract by 2.6 percent annualised this year and to grow 2.2 percent in 2010. Inflation is seen at -0.5 percent and 1.8 percent, respectively.

In the wake of the worst credit crisis in generations, central bankers around the world are reevaluating the old-fashioned approach of leaving asset bubbles to their own devices and then mopping up the mess later. Many officials, including some at the Federal Reserve, are now contemplating a shift in approach.

William Dudley, president of the New York Fed, signaled as much at a conference this week. Answering audience questions at Fordham Law School, Dudley said there was a strong case for reassessing the hands-off attitude. But, echoing a long-standing central bank mantra, he argued that interest rates themselves are too blunt a tool for the job. Adding new policy instruments to the Fed’s arsenal might help (Dudley has previously mentioned regulation would do a better job than rates).

In that context, economists at Morgan Stanley see yesterday’s opening salvo in the global tightening cycle, marked by the Reserve Bank of Australia’s interest rate increase, as the start of a new trend:

“With the RBA the first G10 central bank to raise rates and a Norges Bank hike imminent, in our view, the monetary policy cycle has started turning. Both early hikers are moving while output is still below-trend and inflation below-target, in part because of concerns over house prices. This could herald a new era of central banks ‘leaning against the wind’.”   

BofA Merrill Lynch economist Ethan Harris isn’t buying what he calls ”extreme perma-bear stories” about the U.S. economy. A couple of weeks of disappointing U.S. economic data, culminating in Friday’s weak employment report , revived concerns that the economy was struggling to reach recession escape velocity.

In a research note, Harris said the bad news hasn’t changed his forecast for U.S. economic growth of 3 percent-plus over the next two years. He says the economy has a natural tendency to eventually return to full employment once the “negative shocks” are gone. He points to six major economic theories to support his view, including Keynesian, the Austrian school, and the “financial accelerator model,” which counts Federal Reserve Chairman Ben Bernanke among its advocates. 

But he acknowledges there is one well-known economic theory which does not support his forecast:

“The one notable exception to this view is Marxism. In Marxist theory the capitalist world is doomed to ever worsening cycles of boom and bust, culminating in its collapse and the assent of communism. Needless to say, we do not ascribe to this view.”

Sovereign wealth funds, eager to be accepted in the West, are increasingly interested in showing the world that they care about environment and governance by investing in socially responsible firms.

It all sounds good, but the biggest shortfall of Socially Responsible Investing (SRI) is that it lacks convincing performance details. Therefore, SRI or ethical investing for SWFs is not just about returns: It allows them to combine a multitude of objectives, such as portfolio diversification, enhancing transparency, meeting social goals and gaining acceptance even among critics who suspect they operate politically.

SRI, already a $2.71 trillion industry in the US, involves buying shares in companies that manage environmental, social and governance risks. For example, firms which make clean technologies are in, while businesses that pollute the environment, abuse human rights or produce nuclear arms are out.

Norway is leading the pack with its $400-billion sovereign wealth fund. It names and shames companies the fund expels for not meeting its criteria and pushes the management to be greener.

For more read the analysis here.

Here’s a tip for anyone curious to know where the next generation of monetary policy tools is being dreamt up: Look north.

Sweden’s central bank – which brought us the world’s first official negative rate in July – took another swipe at economic groupthink this week in a paper that argued against a core principle of interest rate theory.

To wit: that savers would rather stuff cash under the mattress than place it in a loss-making bank account.

And with this paper the Riksbank may be sending a discrete signal to other central banks still searching for ways to boost lending in their economies that there's nothing to be afraid of cutting interest rates below zero. 

We already knew the Riksbank had no qualms about charging big banks -0.25 percent interest on their overnight deposits. But households? For Sweden’s Monetary Policy Department, it seems there is no fundamental difference between the way banks and savers behave in times of economic uncertainty — and no reason either would refuse a slight loss on their deposits.

“In practice, the mattress is not a realistic alternative for storing and handling large amounts of cash,” the authors, Meredith Beechey och Heidi Elmér, wrote in an economic commentary published this week.

Due to the cost of safeguarding money, they write, “the public may be willing to accept a slightly negative interest rate.” The real unknown is how much of a loss households and companies would be willing to suffer in exchange for this security.

In case you weren’t depressed enough about the state of the U.S. labor market and the 7.2 million jobs lost since the start of the recession, check out this factoid from JPMorgan economist Michael Feroli:

“We would need payroll gains of 200,000 per month every month for three straight years just to get back to late 2007 levels of employment, and even that calculation ignores the labor force growth over the intervening years.”

Take your pick of bad September job news: the average workweek declined; average hourly earnings increased a paltry 0.1 percent; the broadest measure of unemployment and underemployment rose to 17 percent; and the average duration of unemployment hit an all-time high of 26.2 weeks.

Welcome to the recovery.

U.S. Representative Barney Frank forgot one minor little detail in Thursday’s hearing on overhauling the financial regulatory system — the witness, Federal Reserve Chairman Ben Bernanke.

After Frank and other members of Congress delivered opening statements, Frank launched into a spirited rebuttal of one member’s comments, but was soon interrupted by the committee’s top-ranking Republican, Spencer Bachus.

Bachus: Mr. Chairman, uh, your time has expired. Now if you want to give an additional….

Frank: Excuse me, I’m in my five questions, I’m in my five minutes.

Bachus: How about the opening statement of Chairman Bernanke?

Frank: Oh, I forgot about that. I apologize.

After Bernanke read his statement, Frank offered another apology — and docked himself 30 seconds of speaking time.

Interesting comment coming out of the Reuters Restructuring Summit . John Lonski, chief economist at Moody’s Investors Service, says U.S. demographic trends are the worst coming out of any recession since World War Two, mostly because of the aging baby boomers.

“When you are over 55, you just don’t spend like you did when you were in your early 50s, 40s and 30s. 

The aging of the population is not going away any time soon, so the rate of growth of consumer spending is shifting downward in a lasting manner.”

Dena Aubin has the full story here.

Quite a contrast to the previous day. The permitted march in Pittsburgh was peaceful on Friday.

Reuters correspondent Sumeet Desai talks about the G20 draft communique and what it means for rebalancing the world’s economy.