Is the U.S. economy headed back into recession?

That is impossible to know. The more likely scenario is that the economy does not deviate too far from its current slug­gish pace. But the risks of a more pronounced downturn should not be taken lightly. Uncertainty about the econ­omy, which is linked to uncertainty about the policy envi­ronment that will result from the mid-term elections, is the main reason risk aversion has returned in the financial mar­kets.

What would recession imply for U.S. stocks?

In the correction from the April highs, U.S. stocks have priced in an economic slowdown, but not a new recession with further contraction in employment. If the economy sinks back into recession, stocks will fall below their recent lows and move into bear market territory (defined as a 20% or more peak-to-trough decline).

In that scenario, how much downside risk is there in the stock market?

According to conservative valuation techniques such as the Shiller P/E Ratio, fair value on the S&P 500 is around 900. The combination of abundant liquidity provided by the Fed­eral Reserve and the shortage of attractive investment alter­natives in bonds should provide a floor around this level, and prevent stock prices from moving deeply into underval­ued territory, which has tended to happen in previous secu­lar bear markets. A return to the lows of March 2009 under 700 on the S&P 500 is very unlikely given the unprece­dented stimulus and financial system support that has been applied globally.

What is a reasonable upside target if we avoid reces­sion?

Until the private sector employment backdrop materially improves, the upside in U.S. stocks unfortunately may be limited to the vicinity of the April highs of 1225 on the S&P 500.

How much of a threat is deflation?

Deflation fears are overblown. We have been and continue to be in an environment where inflationary and deflationary forces operate simultaneously. Private sector deleveraging and excess capacity are deflationary. The government pol­icy response of deficit spending and monetary easing is inflationary. The current deflation scare is unfortunate be­cause it is leading to more monetary easing from the Fed­eral Reserve, which is not what the economy needs right now. Interest rates are low enough. They are too low in the case of a zero percent federal funds rate. Europe has as many problems as the U.S. and has held the line at a 1% short-term lending rate, which allows risk-averse savers to earn something on their money. Moreover, a mild deflation­ary environment is not necessarily something to be alarmed about. Historically, stocks have performed well in a mild deflation. Stocks only fall apart in severe deflationary envi­ronments, where the broad consumer price index drops by over 2.5%. We are nowhere near those levels. The overall CPI was up 1.1% in the 12 months ended in June.

What is the appropriate investment strategy for this environment?

This is not an environment to take an aggressive position on a particular outcome because there so many unpredictable variables. The indicators we track, which include funda­mental, technical, psychological, and monetary factors, are mixed. Rather than black or white, we see a lot of gray. Our portfolios are well diversified with a defensive orienta­tion. The primary secular risk remains the debt problem, which has been three decades in the making, and totals over 300% of GDP. A lot of deleveraging still needs to occur in the private sector, and governments need to get on a sus­tainable longer-term fiscal path. Investors are rightly skep­tical about whether the political climate exists to begin to get our fiscal house in order while still fostering private sector growth.

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