Keep an eye on your equities as reflation turns into inflation, says Guy Monson
Keep an eye on your equities as reflation turns into inflation, says Guy Monson
Despite the setback in global markets in February, I still believe that the three-year up trend in world equities remains firmly intact. ‘Reflation’ related assets have certainly corrected this month (among them oil, gold, metals, and Japanese equities), but still seems to me more of a correction within a secular bull market, rather than the start of something more significant.
With 86 per cent of the world’s 42 largest markets remaining well above their ten-week moving average, and almost 98 per cent above their 40-week averages, the technical underpinning to global equities still looks secure.
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Recent economic data does, however, suggest that the global reflation phenomenon of the last three years is slowly moving the world economy itself into a more inflationary phase. While world consumer prices are still low by historical standards, there is now clearly upward pressure from the factory gate, and this is starting to elicit a policy response from central bankers.
For example, even in Japan, where consumer prices have finally risen for two straight months, many are now questioning the wisdom of continuing the ‘quantitative easing’ policy of the BoJ.
In the emerging world, worsening inflationary trends have already triggered rate rises in South Korea, India, Thailand, Malaysia, while there is now evidence of the resumption of an inflationary up trend in Chine. Consumer prices are also influencing policy in the Eurozone, where at 2.4 per cent for all but two months since April 2004.
On December 1, ECB president Jean-Claude Trichet raised rates, the first rise in five years, and is still calling market bets of a further rise in the near future ‘reasonable’.
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I certainly don’t think that equities overall are yet vulnerable to higher interest rates. Typically, equity risk premiums remain at or close to record highs, while in Europe and Japan, dividend yields are still substantially above short-term rates.
Since the first European rate rise in December, equities have actually risen by 7.1 per cent, which is typical of the early stages of a tightening cycle. Indeed, history shows that, as in the US, the ‘three steps and a stumble’ rules applies before the rate cycle actually starts to damage equities.
In other words, I still remain a clear bull of European equities on the back of another exceptionally strong quarter’s reporting season, supported by compelling valuations relative to bonds.
The great regional ‘reflation’ play of 2005 has been Japanese equities. While I continue to be a great long-term enthusiast for the structural changes in Japan (which promise a multi-year secular bull market), I have been cautious since December on the prospects for the market in the short term.
Soaring valuations, excessive foreign participation, and the prospect, eventually, of higher interest rates are together a recipe for a short-term market correction. The 8 per cent fall in the Nikkei from the beginning of February looks justified and, while there are may be some more downside yet, a buying opportunity some time in spring looks like a good entry point for longer-term investors.
By contrast, my other strong ‘reflationary’ call remains physical gold, where we clearly see opportunities to add to positions after the recent price setback. Indeed, the rising volatility for the metal is normally supportive of strong price rises (current volatility is at a level that typically corresponds to 20 per cent annualised returns in the metal, according to Ned Davis Research).
An increase in overall equity volatility is often seen as a precursor of changing longer term trends within markets. In this case we see the beginnings of a rotation between two major industry groups across global equity markets, namely energy and technology.
Both are essentially beneficiaries of a faster growing world economy and global relfation, but over the last 12 months, the MSCI global energy index has outperformed the global technology index by almost 28 per cent. In the case of energy, I certainly acknowledge that in an accelerating world economy global growth will continue to mean rising oil demand, but at current prices, there should also start to be some supply response.
We have already seen Chinese year-on-year oil demand fall below GDP growth; we expect similar responses elsewhere in the emerging world. US oil inventories are also well above ten-year averages and, despite problems in Iran and Nigeria, the market is well supplied with crude.
In comparison, capital spending on technology, which is itself a clear beneficiary of global reflation, is rising, and the sector has seen some of the strongest upward revisions in profit estimates for 2006. Starting to switch energy exposure to Nasdaq by the middle of this year is beginning to look attractive.
There is, of course, one exception to this mildly inflationary trend across global economies and that is the UK. British inflation has remained below the Bank of England’s 2 per cent target rate for two straight months, and retail sales for January proved abnormally weak.
Much depends on the housing market going forward and data here is contradictory. But with market expectations of a quarter point rate cut in the first half of the year, and UK gilts yields relative to the Eurozone at multi-year lows, we expect Sterling to take the strain.
Global investors should be looking to hedge their Sterling exposure, while UK domestic investors have a good opportunity to accelerate their global diversification programmes.
Last year’s gradual move from global reflation to global inflation will continue to gather momentum this year. The impact will be felt first in Asia and the emerging world, but will soon become evident (in even the consumer price indices) in much of the Western world by year end.
While in itself it will not end the strong rise in global equity markets, it does pose some real challenges for asset and stock allocation in 2006.
