Global investment strategy: Is low inflation an oasis or a mirage?
Is the Anglo-Saxon world of strong economic growth and low and stable inflation an oasis or a mirage? Judging by the way financial markets reacted to a chorus of Federal Reserve commentary and a slew of economic data last week it was a mirage that inevitably will fade.
Friday, October 14th 2005, 10:12AM
In March-April of this year the Australian and US share markets fell 8.1% and 7.7% respectively on concerns that higher oil prices and unrest in the Middle East would cause inflation and lead to slower growth. As we now know, those declines proved temporary and both markets reached new highs shortly thereafter.
But what if markets are not wrong this time? Certainly there is stronger evidence that inflation is starting to creep into the global picture. Inflation and inflation expectations have risen in the US. Labour costs have risen on the back of slower productivity growth and higher wages.
In Europe, policy makers are contemplating raising rates on the back of rising wage costs and higher energy prices.
In Japan, talk of inflation may yet be premature, but deflation is expected to come to an end by next year. This comes as signs of life start to emerge in the Japanese domestic economy. Japan’s banks are creating credit for the first time in the seven years data are available, for example.
The implications are potentially very serious for investors if the crystal ball of the market proves to be correct. We may be at the start of, perhaps a long, journey toward correcting some of the world’s saving and growth imbalances.
First, it may mean higher long-term bond yields – particularly in the US. If deflation really is approaching an end in Japan, there will be less need for authorities there to sell yen for US dollardenominated Treasuries.
Second, higher inflation means US interest rates will need to move higher than expected, placing an even greater weight on the shoulders of US consumers. Slower growth in the US will place greater pressure on the rest of the world to rely less on exports and more on their own domestic demand.
Third, the dollar may come under downward pressure. If there is a shift in thrift toward the Anglo- Saxon economies and away from Europe, China and Japan, investment outside of the US may become relatively more attractive. Any difficulty the US would have in funding its current account deficit as a result would suggest downward pressure on the dollar and or upward pressure on interest rates.
Finally, if inflation is on the rise, risk premiums must also rise. This would put downward pressure on the price of risky assets such as shares and housing. Even Fed Chairman Alan Greenspan admits “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.” Given the seriousness of the consequences that may flow from a world characterised by higher inflation, it is no wonder the markets reacted as they have.
If a transition is at hand (which seems increasingly likely), chances are it will be slow to materialise. The birth of a consumer culture in Europe, Japan, and China will require companies in those countries to become more competitive in order to grow and attract foreign investment, and ultimately grow employment and consumption. This process has only just begun.
For investors, the strategy remains the same – beware of bonds, and US dollars. Equities still remain the most favoured asset class, with Europe preferred to the US. China will remain a key engine of growth and so will continue to support the Asia-Pacific region. The pull-back in Australian shares more likely represents a short-term correction than anything more fundamental. History suggests the correction may not be over so any further pull-back may best be seen as a buying opportunity.
This article is supplied by BT Funds Management
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