Private credit might be less attractive than it was last year as investors rush into the market, but there are sweet spots to be found.
Concerns about the global credit crunch and the US housing slump have been supplanted by worries about global inflation, notes Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors. This is evident, he says, in surging bond yields and tough anti-inflation talk from central banks.
ôFor investors, rising inflation is bad news, particularly if it becomes entrenched,ö Oliver says.
High inflation undermines real asset values, pushes up the yields investors require to invest, reduces the quality of company earnings, distorts economic decision making and ultimately leads to lower economic growth and rising unemployment. Still, Oliver says the current situation begs the question: how real is the threat?
Indeed, while todayÆs inflation rates are way below the double digit levels of the mid-1970s, there are reasons for concern.
ôInflation is above target in most rich countries, it is up virtually everywhere and it is leading to a rise in inflation expectations which threatens second round effects,ö Oliver says.
Data compiled by AMP Capital Investors, a Sydney-based investment management company with $111 billion in assets under management, compares the latest available inflation numbers to 12 months ago:
US - 4.2% vs 2.7%
Japan - 0.8% vs 0.0%
Eurozone - 3.7% vs 1.9%
UK - 3.0% vs 2.8%
Australia - 4.2% vs 2.4%
China - 7.7% vs 3.4%
India - 7.8 vs 6.7%
Asia - 6.1% vs 1.9%
Latin America - 6.8% vs 4.6%
Eastern Europe - 8.2% vs 5.3%
Surging food and energy prices are the common factor behind rising inflation worldwide. In the G7 economies, average headline inflation is above 3% but core inflation û which excludes food and energy û is still around 2%. In Australia, the problem has been broader than just oil and food. Inflation excluding petrol and food was 3.2% over the year to the March quarter and the Reserve BankÆs measure of underlying inflation was running at 4.3%.
Asia has seen a more broad-based pick-up in inflation, Oliver notes. Higher food prices have had a greater impact because they typically have a 30% weight in Asian consumer price indices (versus 15% in rich countries). The combination of strong demand, waning excess capacity from the late 1990s Asian crisis and undervalued exchange rates have seen underlying inflation rise as well in several Asian countries, although not so far in China.
However, Oliver expects inflation to ease over the next 12 months. ôItÆs hard to see it going too much further,ö he says.
The first thing to note, Oliver says, is despite the surge in food and energy prices which also occurred in the 1970s, there are big differences between now and then, which should prevent high inflation from becoming entrenched.
ôWe havenÆt seen the huge productivity zapping expansion in government that occurred into the 1970s,ö he says.
The global economy is now far more competitive following the end of the Cold War. Labour markets are generally deregulated, union membership is down sharply and centralised wage setting in Australia is a thing of the past. Independent central banks have taken monetary policy away from politicians and inflation targeting helps anchor long-term inflation expectations.
With the downturn in global growth now underway, that will likely lead to lower inflation over the next year as excess capacity is freed up, Oliver says. After all, every major economic downturn in recent times has led to lower inflation, he notes.
One reason inflation became so entrenched in the 1970s was that higher fuel and food costs fed into wages growth, creating a wage price spiral.
ôToday there is no evidence of this,ö Oliver says. ôWage growth in most countries has remained pretty benign.ö
Oliver also expects to see some short-term relief in food and energy prices. Agricultural commodity prices after going exponential into early this year now seem to have entered a range trading period, he notes.
While oil is still in the blow-off phase itÆs likely that it too will soon enter a range-trading environment as slowing global growth cuts into oil demand leading to an unwinding of speculative positions. While some are entertaining the possibility of oil rising to $200 per barrel, AMP Capital Investors sees oil price falling back to about $100 per barrel ôsometime in the next six monthsö, which in turn will cut headline inflation rates substantially.
There are a number of longer-term issues regarding inflation, including whether Asia is becoming a source of global inflation and the implications if Asian countries allow their currencies to strengthen to combat inflation.
AMP Capital InvestorÆs key conclusions are that the next few months are likely to remain challenging for share markets as inflation and interest rate worries add to concerns about weak growth. It believes inflation concerns will abate later this year, however, in a lagged response to slower growth and the falling oil prices that it expects. ôThis should be positive for shares into year end,ö Oliver says.
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