The credit crisis has put an end to the ability of monetary authorities to smooth business cycles, and therefore recessions will become more frequent, says Albert Edwards, London-based economist at Société Générale. He adds that another downward cycle in developed countries is likely to strike some time in 2010.

"The world economy will go into another recession more quickly than people expect," says Edwards, a self-confessed macro bear. His model portfolio has been overweight government bonds versus equities for the past 13 years. 

Although deflation will be the main challenge for policymakers in the coming year or so, he also suspects very high levels of inflation could make an appearance in 2011. The UK suffered from inflation of more than 30% at one point in the 1970s, a calamity largely forgotten today, adds Edwards. Inflation is inevitable because so many governments in Europe, the US and Japan are headed for insolvency and some will be forced to go into default.

"The fact that markets feel pretty good right now does not mean we have entered a self-sustaining recovery," he adds.

On a 10-year basis, says Edwards, performance in US equities is well below that of US government bonds. "You must have doubts about equities," he concludes. Although if one accepts the principle of mean reversion, equities should look attractive on a 10-year forward basis, but remain overpriced in the shorter run, over, say, a one- or two-year period.

Even at global stock markets' nadir in March, stocks were overvalued, Edwards argues. This may seem incredible, but that's only because investors had gotten used to "ridiculous" valuations over the past 15 years. He expects another drop in the S&P 500: "De-bubbling takes cycles to work itself through. The market will look for a reason to complete its devaluation."

He wouldn't be surprised if the S&P 500 Index drops below 500 points, even as low as 400, sometime in 2010. One possible trigger could be fears about future inflation prompting bond yields to rise and expected damage to price/earnings ratios of stocks. This is the mechanism that has undermined Japanese stock prices throughout much of the country's post-1989 bubble economy, says Edwards.

Equities have seemed cheap because they've been so expensive for so long, and because they've performed well in the wake of the US Federal Reserve's habit of slashing interest rates whenever the economy seemed to hit a wall. But with the Fed having retreated to quantitative easing, it can no longer support sustained equity prices. This year's bull market in stocks has occurred thanks to fiscal and monetary support, and is dependent upon such policies continuing.

With central banks unable to continue to support economic growth by borrowing, the period known as the Great Moderation, which began in the early 1980s, is over and will give way to trends typical before World War II. Edwards notes that the period of 1875-1939 in the US was marked by a constant refrain of boom and bust.

He thinks the world economy, particularly in the US and western Europe, can't sustain the recovery. There are plenty of ways to tip these nations back into recession: one is the huge amount of dodgy mortgage loans in the US that reset starting next year. Another would be an end to fiscal or monetary stimulus.

And once the cycle turns negative, capital flows will quickly retreat to bonds, even if just on a temporary basis.