Global Spotlight - June 2011
Prior to the financial crisis the major economies of the world exhibited a remarkable degree of correlation, characterized by stable growth and low inflation. This stability has now disappeared: different countries are showing very different paths while inflation concerns are much greater. How can investors protect themselves in this more challenging environment?
When we look at the world economy we can see different governments responding in different ways to today's problems. For example, the US authorities clearly have their foot hard on the accelerator, with both fiscal and monetary policy at highly stimulatory settings. Compare this to the UK where fiscal policy is being tightened sharply; loud is the debate over whether monetary policy should turn the same way. Meanwhile the ECB has recently started tightening interest rates, despite the Eurozone sovereign debt crisis continuing to rage on. Lastly, China and other Asian central banks have been tightening policy for many months.
Two factors contribute very greatly to this divergence. First, the aftermath of the crisis left the various economies in different states of repair. The US economy shows all the classic signs of a large output gap, that is a significant amount of slack that needs to be taken up before any inflation could be generated domestically. Meanwhile the signs in the UK are less clear, with unemployment not as high as most estimates of the output gap would suggest, so the degree of spare capacity is a matter of conjecture. The Eurozone is, of course, a large diverse region, with core economies, especially Germany, performing very well, say in terms of improving unemployment, while the periphery is still mired in crisis.
The second major contributor to this divergence is the fact that much of what is driving inflation in the major economies is now generated externally. The rise of the emerging nations in the East has huge implications, and not simply for raw commodity markets. Such externally generated influences are harder for domestic economies to control than internal factors; how, for example, should central banks react to a jump in oil prices? Is it appropriate to use monetary restraint to head of a non-monetary imbalance in the economy?
The answer to this may lie in the next stage of the process, or the second round effects as economists like to call them. If higher food and fuel prices, driven by strong external demand, lead to higher wage pressures, or companies announcing much higher goods and services prices, then there is clearly a domestic problem.
Some central banks will wish to head this off, if they can. The ECB has spoken of the need to be pre-emptive, albeit the signs of second round effects are still anecdotal outside of Germany where some unions are beginning to flex their muscles. For the UK, some union pay deals are a warning sign but overall pay deals are rising slowly. Further afield, the US remains subdued in growth, and wage deals there appear to be subdued. Its housing market remains in a dreadful state, and negative equity is forming a major constraint to labour mobility.
In conclusion, investors need to examine the global inflation backdrop and the rather different policy responses between countries. One avenue is to pick and choose between inflation linked bonds issued by different countries, whereby an investor can exploit moves in relative inflation and interest rate expectations. Such bonds are a real asset class, with an explicit link to inflation, but should be poorly correlated with other, riskier, real assets such as equity or property. In this sense they can be a powerful diversifier, improving the risk return characteristics of a multi-asset portfolio.
Jonathan Gibbs, Investment Director, Fixed Interest, Standard Life Investments
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