Opinion

A Mexican stand-off

Finance | 27 Jul 2008

Richard Urwin discusses the economic outlook for the next quarter and beyond.

We are seeing a real tug of war between the conflicting forces of rising inflation and slowing growth. Inflation has risen to the top of investors’ agenda as headline inflation is accelerating across the world on the back of higher commodity and food prices. The UK has been no exception to this trend, with the latest CPI figures reaching 3.3 per cent. Further inflationary pressure is likely, but so far there has been little sign of acceleration in ex-food and energy inflation and little sign of wage acceleration.

At the same time, the slowdown in growth continues unabated, albeit with varying intensity across the world. While the US economy is flirting with recession, growth in other regions has so far remained robust, with both Europe and Japan surprising on the upside. However, recent signs point to a more pronounced slowdown in both regions and further moderation in the hitherto boom-ing emerging markets. The UK economy for its part has clearly slowed and we expect the slowdown to gather pace. While personal consumption remains surprisingly strong, there is clear evidence of housing market weakness and declining consumer confi-dence, which eventually will lead to weaker consumption growth. Combined with sub-dued capital growth this will translate into a period of exceptionally sluggish growth.

It is particularly hard to determine which of these two competing forces will get the upper hand. The most likely outcome is that slowing growth will eventually dampen commodity prices and therefore lead to a reduction in headline inflation. The extent to which the Bank of England and other central banks may have to raise rates to prevent sec-ondary inflation remains, however, an area of concern. Indeed, the longer the period of elevated commodity prices lasts, the greater the pressure will be on central banks to back up their rhetoric with policy action. Already the European Central Bank has signalled an increase and the market is now anticipating tighter rates from the Bank of England and the Federal Reserve as well. While rising core inflation is making further tightening likely in the emerging markets, the level of interest rates rises currently discounted in the money markets for the UK and other developed economies is exaggerated.

While the Fed’s rescue action of Bear Stearns and concerted liquidity injection by the Bank of England and other central banks has significantly reduced the risk of a global financial meltdown, the difficult and some-what opaque macro-economic background outlined above will continue to weigh on both equity and fixed income markets. On most valuation grounds, UK equities now look generally cheap. Profits growth expectations are also low. However, with two-thirds of UK corporate profits being made overseas much depends on the global outlook. It remains, however, difficult to make a really positive case for corporate profits growth, given the loss in global economic momentum. It is fea-sible that equity prices will move back to the recent lows, but we do not expect them to be breached as valuations and eventually policy easing will provide support. At the same time, a better profits background will be required for a sustained break on the upside. In the meantime, choppy and at times violent range trading appears more probable.

Bond yields have increased significantly from the March lows with significant repric-ing on the basis of expected central bank activity into 2009. However, not all the priced in interest rate rises may materialise. Credit spreads generally narrowed in May, reflecting diminished risk aversion across a range of asset classes. While we cannot exclude the possibility of nasty aftershocks as financial institutions continue to face write-downs as a result of sub-prime exposure and the effects of a slowing economy and real estate market, we believe the market distor-tion offers opportunities for investors who have the experience and the research and risk management capabilities to undertake care-ful security selection. Increased volatility is a further reminder for charities to ensure their investments are sufficiently diversified.

Richard Urwin is head of economics and asset allocation for the multi-portfolio strategies group at BlackRock
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