Jul 7 2008
Central banks could be left playing Russian roulette as inflationary pressures mount, the JP Morgan Weekly Strategy Report warns. Writing in the report, David Shairp paints an economic picture vastly different from the one seen just a few months ago when further interest rate cuts were being widely predicted for western economies. Now it seems more likely that rates will increase as inflation dominates both the financial and news headlines. He quotes Jean-Claude Trichet, president of the European Central Bank (ECB), as saying that rate increases in the euro zone are "possible" and that the bank is in a state of "heightened alertness" as prices continue to rise.
Meanwhile, Mr Shairp states that the US Federal Reserve has dropped "a bombshell" by saying it is prepared to take action in order to ensure that the dollar remains strong. He points out that currency matters are usually the domain of the country's treasury and that the Fed's comments seem to indicate that it is willing to do more than just change interest rates.
His colleague Tom Elliot is also keen to sound a note of caution. Writing in his Investment Outlook Mr Elliot points out that rising unemployment in the US and falling consumer confidence in the UK indicate that the "broader economic outlook is deteriorating". Meanwhile, countries in the euro zone are increasingly economically vulnerable due to the area's strong currency, Mr Elliot claims. These negative factors, combined with uncertain predicted earnings (PE) forecasts, outweigh the historically cheap stock valuations, he explained.
The Barings Global Weekly Review also picks up on the threat of inflation to the UK economy. It cites the Bank of England's latest quarterly survey of expectations on the matter which found that the average UK resident thinks that prices have risen by 4.9 per cent in the last year - a figure that is much higher than the official Consumer Price Index (CPI), which currently stands at three per cent. Inflation worries are not only limited to the public, the report points out, with the Office for National Statistics revealing that producer inflation hit 8.9 per cent in May. According to Barings, the combination of these two factors might mean that the Bank has to increase its base rate "several times over the next year", despite the economic downturn caused by a slowdown in the UK's construction industry.
Further afield, the report points out that economic growth in Japan is believed to have peaked for the current economic cycle. It quotes the country's cabinet office as stating that the longest continuous period of growth the nation has experienced since the end of the Second World War appears to have come to an end. It also highlights concerns over rising energy prices in Japan. According to Barings this has led to a 17.5 per cent fall in corporate profits as firms are unable to pass on the higher costs to consumers.
Barings also points out that inflationary pressures are not only a concern for western economies, with several developing economies increasing interest rates in order to ease the situation. Central banks in India, South Africa and Brazil have all been forced revise rates upwards in recent months. The major exception to this situation is South Korea. The Asian country has actually being trying to boost consumer spending through tax cuts after higher energy prices cut the purchasing power of households and small firms, the report reveals.
The threat of inflation also raises its head in the Threadneedle Investment Strategy report for June, albeit in a slightly more positive manner. According to Sarah Arkle, chief investment officer for the firm, while increasing oil prices are driving headline figures up, this should not lead to higher levels of inflation across economies as a whole. She cites the example of the US CPI - which excludes food and energy. Ms Arkle explains that this has "eased in recent months" as housing costs fall and consumers tighten their belts. Wage increases in developed economies have also remained relatively subdued and the combination of all these factors should mean that a return to stagflation should be avoided, she believes.
The rising cost of oil and "the fundamentals of supply and demand" mean that it is likely investments in the energy sector will continue to offer good returns for investors, she predicted. However, inflationary pressures make equity markets less attractive and emerging economies as well as those in the Pacific Basin area - excluding Japan - could be hit hardest, at least in the short-term, Ms Arkle cautions. Despite this the potential for strong growth should see equities in such countries "outperform over the medium term", she added.
Predication of strong growth in Asian markets seems to be born out by the Invesco Perpetual Asian Market Update. The report states that some nation in the region "reported much better-than-expected" economic growth figures for the first quarter of this year. It points out that the Indian economy grew by 8.8 per cent year and year, with Malaysia, Hong Kong, Thailand, Taiwan and Indonesia also reporting good levels of expansion, the report adds. The report does agree that inflation is an issue for the region and highlights the fact that the People's Bank of China has already increased interest rates to 16.5 per cent. The Bank of Indonesia also increased the cost of borrowing to 8.25 per cent "with strong indication of further increases to come", the report concludes.
However, writing in his weekly blog, Leigh Harrison, head of UK equities at Threadneadle warns that the current economic slowdown might take longer to play out than people expect. He said: "The current environment is more like a slow motion car crash than the rather more spectacular busts of the eighties and nineties." Mr Harrison believes that although this means things could drag on for longer than some would have liked, it will also make the situation easier to manage "unless a major policy error occurs". No matter what happens he expects the coming months to be "a real test of investors' skills".
