Inflation pressures suggest a need for vigilance

With economic indicators suggesting that inflationary pressures are increasing, investors should consider the possible impact on their portfolios.

New Star’s economist, Simon Ward, outlines the current inflationary risks and New Star’s joint chief investment officer, Gregor Logan, explains his recent shift in asset allocation.

New Star’s in-house analysis has for some time suggested that inflation would rise and bond yields would, as a result, increase. Bond markets have, as expected, weakened recently and there are indications that inflationary pressures are beginning to bite.

Simon Ward identifies two catalysts. First, broad money supply growth in the Group of Seven (G7) major industrial nations has been accelerating since 2004 and is now above its long-term average. Money tends to lead inflation by about two years on average, so current strength suggests there will be upward pressures on prices in 2008 and 2009.

Secondly, recent strong output expansion has eroded spare capacity in the world economy, reducing competition and giving firms more “pricing power”. G7 industrial capacity utilisation is at its highest level since 1998. New supply from emerging markets provided a safety valve earlier in the decade but many of these economies are also now hitting capacity constraints.

Central banks and markets were hoping that a moderation in economic growth would relieve capacity pressures but the slowdown to date has been modest. It is now likely that there will be a reacceleration as the US economy pulls out of its recent soft patch. This raises the possibility that monetary policy-makers may be forced to tighten by more than investors have expected.

Bond markets have already partially adjusted to this changing outlook but G7 10-year yields ended last month still slightly below New Star’s estimate of long-term fair value. They may need to rise above this level to compensate investors for increased medium-term inflation risks.

The issue for investors is whether equities can decouple from the weakness in bonds. There are two reasons for thinking they might as long as the bond market sell-off remains controlled. First, relative equity valuations still look modest – although there is a question mark over the sustainability of current profitability levels. Secondly, global money growth continues to outpace economic expansion, so the liquidity environment for markets remains favourable. Disillusionment with bonds suggests that much of this cash will be directed towards equities.

Gregor Logan, New Star’s joint chief investment officer, says: “In terms of asset allocation, an overweighting in equities will have proved prudent in recent months. With longer-term government bond yields in the Group of Seven countries still below New Star’s estimate of fair value, further rises in bond yields remain likely. While this suggests equities will need all the help they can get from earnings growth, fortunately, monetary trends support the recent increase in optimism about global growth prospects in general and US economic prospects in particular.”

“Within the equity markets, Europe has been the focus for many investors for much of last year. Japan, however, now offers strong growth potential. The Japanese stockmarket underperformed the rest of the world significantly during 2006 and during the early months of 2007 and a better relative performance over the rest of this year is possible. Indeed, leading indicators suggest Japanese and US stockmarkets may now be bottoming out. While investors need to remain vigilant of the risks of rising inflation, they also may wish to consider rotating their portfolio as the potential for growth appears to shift.”