The Return Of Inflation

LONDON, May 30 — Surging oil and commodity prices coupled with a falling dollar are prompting some investors to brace for a return of inflation, which would benefit equities and damage most government bonds. Inflation — which in the short to medium term benefits equities and risky assets because of rising prices — had all but disappeared after the global economy fell into recession and commodity prices sank last year.

However, signs of a global economic recovery — which next week's manufacturing and service sector surveys and other data could reinforce — are leading to a renewed surge in energy and commodities and the outperformance of inflation-protected debt securities over benchmark government bonds.

Oil prices are nearly double their four-year low in December. The Reuters-Jefferies CRB index, a global commodities benchmark, has hit a six-month high while the Baltic Dry Index, which tracks rates to ship dry commodities, has risen more than 320 percent since the start of the year.

To exacerbate matters, the dollar is on track for the worst monthly performance since December 2008, which could further fuel buying in dollar-based commodities.

The return of inflationary forces at a time the world is grappling with the threat of deflation, could prompt investors to invest in assets such as stocks because rising prices erode the value of cash. Already struggling government bonds, apart from inflation-linked debt, could come under further pressure.

"We're in a reflation trade. Confidence is off its low from March and asset prices are rising. The beneficial period will continue until we find reasons to be pessimistic again," said David Miller, partner and head of alternative investments at Cheviot Asset Management.

"People are getting out of the dollar, into commodities, into equities... Selectively there are reasons to buy commodities in a portfolio."

Miller said while the commodity supercycle might not materialise, crisis-related factors such as the absence of farmers credit are constraining supply and pressuring prices.

The renewed surge in commodities is boosting related stocks. In Europe, basic resource stocks have risen by 45 per cent this year, compared with a four per cent rise in the pan-European FTSEurofirst 300 index.

And investor flows support the move. According to fund flow tracker EPFR Global, fresh money found its way into commodity and energy sector funds in the week to May 27, with these funds posting inflows of US$303 million (RM1,060 million) and US$153 million respectively.

Next week's US personal consumption expenditure data — the Federal Reserve's favourite measure of inflation — is likely to show however that price rises remain moderate in the short term.

Purchasing managers surveys in manufacturing and services sectors and US jobs data would be key in offering the state of the global economy. Central banks from Britain, the euro zone, Canada and Australia decide on interest rates.

Government bond markets could become a source of destabilisation for investors next week given rising concerns about burgeoning Western government debt. The US Treasury alone needs to borrow a record US$2 trillion in 2009 to help fund a US$1.8 trillion fiscal deficit.

Falling government bond prices are pushing up yields, which also affects long-term borrowing costs for governments as well as businesses and threatens to choke off an economic recovery.

US Treasury Secretary Timothy Geithner, who visits China next week, is expected to reassure Beijing that the Obama administration will move swiftly to get its debt under control.

Buying by Asian nations, including China, is crucial in maintaining the stability in the US Treasury market. A weakening dollar is a double-edged sword for buyers as it makes Treasuries cheaper in the long term but it erodes the value of their current holdings in the short term.

The benchmark 10-year US Treasury yield rose as high as 3.7538 per cent on Thursday, its highest since November.

The 10-year US breakeven rates — the yield gap between inflation-linked bonds over equivalent nominal government bonds — have risen to 1.8760 per cent, compared with around 0.2 per cent at the start of the year, reflecting the view that fears of deflation have subsided.

"Investors are realising that by investing in an inflation-linked product... they are able to mitigate the risk that these anticipated inflationary pressures pose," said Jonathan Gibbs, fund manager at Standard Life Investments.

"The combination of a complex mix of inflationary and deflationary forces at play in the global economy, and the great uncertainty which is likely to prevail, means that diversified risk is more important than ever." — Reuters