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taking stock

Carmen Reinhart, right, and Kenneth Rogoff have distanced their work, which has influenced austerity supporters, from European politics.MARY F CALVERT/The New York Times

The brief age of austerity is over. That became clear late last week when the German government, the leading advocate of the economy-starving regimen, reversed course and said it would back a proposal to give the beleaguered French another year to get their budget deficit below the European Union's 3-per-cent target. There was even talk that Berlin would support a modest rate cut this week by the European Central Bank.

Then, on Friday, prominent U.S. economists Carmen Reinhart and Kenneth Rogoff, whose research provided the intellectual ballast for the austerity push but whose math and conclusions have recently been called into question (they admit the math error but defend their findings), declared in a remarkable New York Times opinion piece that they had never advocated austerity as a solution to fiscal ills and high debt levels in a period of slowing economic growth.

"The politically charged discussion, especially sharp in the past week or so, has falsely equated our finding of a negative association between debt and growth with an unambiguous call for austerity," they wrote. "Our consistent advice has been to avoid withdrawing fiscal stimulus too quickly. …"

It seems unlikely that Berlin's abrupt change of heart came from reading the Times op-ed pages, where regular columnist Paul Krugman has been skewering the austerians for ages.

But it did coincide with a Spanish government declaration that it will need an extra two years to meet EU-approved budget targets, as well as calls from Enrico Letta, the latest choice for Italy's prime ministerial hot seat, to abandon austerity in favour of policies that foster growth.

Mix in the Federal Reserve's seemingly permanent easy monetary policy, heavier bank lending in China and Japan's all-in gamble that it can conquer chronic deflation and restore stable growth with a combination of looser monetary and fiscal policies, and we appear to be returning to a growth-above-all world view.

Which means we are also likely to be living with more market uncertainty and volatility for years to come.

Investors need to recognize the consequences of these policies and how to better equip themselves to navigate them, says Chris Kresic, co-chair of the investment strategy committee at money manager Jarislowsky Fraser. "Financial market instability is one of the consequences."

Indeed, at least one Fed official acknowledges as much. Minneapolis Fed president Narayana Kocherlakota recently warned us to expect years of instability, some inflated assets and maybe even another destructive bubble, thanks to record-low interest rates that could run another five to 10 years. And that's from a long-time dove who heartily supports more stimulative monetary policy.

"I've suggested that it is likely that, for a number of years to come, the Federal Open Market Committee will only achieve its dual mandate of maximum employment and price stability if it keeps real interest rates unusually low," Mr. Kocherlakota recently told an economics conference in New York. "I've also argued that when real interest rates are low, we are likely to see financial market outcomes that signify instability."

The upshot is a world of higher risks, more extremes and occasional blowups, but also big market moves upward from time to time, "depending on which way the policy is leaning at one point or another," Mr. Kresic says.

Aggressive intervention was crucial to prevent the global financial system from collapsing in 2008-09. But policymakers "have passed the point of helping long-term economic prospects and are now detrimental to the outlook, given the imbalances they are creating," he argues. "What we're saying [to investors] is you have to focus on quality companies that can survive through the thick and thin of these distorted, imbalanced economies that we're seeing around the world."

This approach tends to produce more of a bias toward large-cap companies in consumer staples, health care and other defensive sectors. "We always look for the small guys who are going to become the big guys, if they have something special. But you're going to end up with the steady Eddies that have been able to prove that they can grow their earnings consistently over a long period of time."

Jarislowsky Fraser's current favourites include such household names as Diageo, 3M, Nestlé, HSBC, and the Bank of Nova Scotia.

"It's more about capital preservation, rather than riding the latest bubble, because that's fraught with danger, more so than ever. You can't get caught up in the momentum trade."