22/07/08
Stepping off the inflation see-saw
Investors face considerable risks and profitable opportunities in the months ahead. Financial markets are responding to various shocks: the global credit crunch, lower property prices, inflation and higher interest rates. Having analysed these issues in detail, our first conclusion is while the authorities can contain the global credit crunch, resolving it will take time and involve many banks raising a considerable amount of new share and debt capital. Secondly, the world economy will, at best, suffer from a period of weak growth, to bring inflation under control, with risks of recession for some countries, including the US, the UK and parts of Europe. Thirdly, investors should pay close attention to the decisions of central banks in emerging economies, where policy errors are possible.
As the global credit crunch has evolved, governments have become better equipped to prevent further bank collapses. Even so, there will be no quick fix, with organisations such as the IMF predicting a further round of banking and insurance write downs. Although only the ECB, amongst the major economies, has tightened official interest rates in recent months, in effect there has been a policy tightening as hawkish statements from central bankers about the need to control inflation affected UK and US money market and thus mortgage rates. Tighter credit conditions, alongside expensive fuel and energy, are squeezing consumer incomes and company profits. The impact has been seen on confidence, high street spending and business investment; share prices are responding. However, these pressures do not bode well either for the residential or commercial property markets. Although builders are reacting to falling house prices and mortgage approvals by cutting new starts, the internal dynamics suggest these sectors are unlikely to stabilise before mid 2009.
Inflation is attracting headline attention. We believe the situation is more serious in global emerging economies. Here, social discontent could mean that governments are too lax in their monetary tightening. Although headline inflation worries policy makers in the UK and other developed countries, the good news is that core inflation, excluding food and energy, is steady. If this changes, as second round effects are seen in higher wages or service sector prices, the policy response and market reaction could be aggressive. Our central assumption is that commodity prices will stabilise, moderately below current levels, as demand falls back over the next 18 months. Hence, central banks are strongly hinting that they would rather leave policy on hold, as unemployment rises to control the inflation situation.
Where can investors find cause for cheer? There are major differences from the last bear market in 2000: companies are not over-extended, their balance sheets are robust, and hence aggressive job cuts are uncalled for. Although emerging market economies will slow into 2009, they should continue to outpace developed economies, as much of their investment is linked to long-term infrastructure and development plans. Policy makers are well aware of the risks facing financial institutions, hence the speed with which they support banks in trouble. Volatile markets do mean short term pain for investors, but for those with cash to put to work they will see some good long term valuation opportunities, both in sectors such as financials or retail, or in markets such as corporate bonds, then equities, and then property, in coming months.
Andrew Milligan, Head of Global Strategy at Standard Life Investments
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
Standard Life Investments may record and monitor telephone calls to help improve customer service.
All companies are authorised and regulated in the UK by the Financial Services Authority.
©2008 Standard Life Investments.
