It was meant to have gone the way of polio, a disease that has been all but by immunisation policies, but soaring fuel and food costs are driving growing concern about inflation. Thomas Della Casa, Head of Reasearch at Man Investments, explores the risks of rising prices and how they could impact investors

 

Inflation has become a quaint concept in developed economies, a historic anomaly occasionally seen in industrialising nations. The last serious bout of inflation in the US and Europe was during the late 1970s, when headline consumer price inflation hit double digits, but that was a consequence of the rigid financial system of the day and central banks were far more politicised.

Back in the day
Markets were different in the 1970s. Trade barriers, subsidies, monopolies, cartels and strong unions were common in those days. Protectionism was a widely spread phenomena, a huge drag on economic development and an important factor that contributed to rising prices.

But all that was meant to have changed: central banks were given their independence and a clear mandate to fight inflation while globalisation and anti-trust legislation brought down trade barriers and restricted market protection. Inflation, it was hoped, had been tamed forever.

That hope is wilting, however, as fuel and food prices continue to soar evens the global economy appears to be cooling, prompting ominous warnings of stagflation – a portmanteau term for inflation coupled with stagnation.

Is it a threat?
So, how real are these concerns? In the short term they are certainly real enough. Soaring fuel prices are being felt at the pump and consumers are spending a higher proportion of their income on food and other necessities. Also, lax monetary policies abroad, especially in economies in which currencies have been pegged to the US dollar or where officials maintained them at undervalued levels, have helped push up inflation in many other regions. The effect is even more severe in emerging economies as energy and food account for a larger share of consumer budgets.

According to the Organisation for Economic Cooperation and Development, prices in its 30 member states were 3.5% higher at the end of Q1 2008 than they were in the same period the previous year. That compares to an annual average gain of 2.5% over each of the previous three years. Prices in Europe were up 3.6% and 4.1% in the US.

While those numbers are hardly on a scale with the 1970s and early 1980s, they are well above the norm and pricing pressure is likely to intensify in the coming months, especially if fuel and food costs remain high. Inflation is a lagging indicator – most businesses actively hedge their exposure to changing prices, and it can take between 12 and 18 months for a peak in fuel or food costs to filter through to the wider market – so it seems likely that the current upward trend in prices will continue, at least for a little while.

Slowdown
In developed countries, however, weak property markets, productivity gains, lower capacity utilisation, higher unemployment rates and slowing economic growth should have a deflationary effect over time while tightening consumer credit should also rein in prices. Central banks – except for the European Central Bank – are only now beginning to act on inflation, but interest rates in the US in particular are comparatively low, leaving plenty of room for further action.

It seems reasonable to expect that price pressure will ease over the next 12 to 18 months in developed regions as private households and banks look to reduce leverage. In particular banks seem to be cutting leverage as aggressively as they once expanded their balance sheets.

All of which is likely to be bad news for borrowers and, by association, equity markets. Higher interest rates and depressed spending will most likely slow or even halt corporate earning growth and have a negative impact on investor sentiment. The lack of confidence could lead to a further contraction in price earnings; ratios and equities – despite the unfortunate start to 2008 – could remain under pressure. So, it is probably too early to call the bottom of the market yet. This mixed view of equities, some technically oversold, some potentially still overvalued, could create selective opportunities for equity hedge managers.

A bumpy ride
On the other hand, higher inflation and interest pressure is likely to contributesignificantly to market volatility as it becomes harder to set a value on goods, products and services. That could benefit global macro funds, which returned 11.1% in 2007 and 5.4% in the first five months of 2008*, and managed futures should do well too. Relative value strategies typically also benefit from higher volatility, as there are more opportunities for them to trade. Generally, the combination of weak equities, recessionary fears and increased volatility should remind investors of the need to diversify and create a positive environment for alternative investment with fresh demand for uncorrelated sources of return.

In short, while higher inflation is a reality it seems unlikely that the market will experience anything close to the levels seen in previous cycles and any spike in pricing should create numerous opportunities for hedge funds. Investors should be aware of inflationary pressure, but rather than fear it they should be encouraged to position themselves to profit from it.

*Source: HFRI Global Macro Index.