Evercore Pan Asset

There are no certainties in the investment world, but the idea that 2011 will see higher interest rates is one of the less contentious predictions. We have already seen emerging market countries push up rates to combat rapid money and credit growth and rising inflation. There is some sign that China is beginning to get on top of its run away economy, whilst India still has much to do. Most people expect the European central Bank to hike rates soon, the Bank of England to follow probably in May and eventually the Fed. Most still expect the increases to be modest in scale and relatively slow to come.
 
We need to remember that over the last year all the surprises have come in the form of faster inflation than many expected. The pessimism of the commentators a year ago, still claiming the west had to do battle with deflation, has been replaced by a schizophrenia about inflation. The hawks think it can get out of control, and strong action is needed by the authorities to rein in it early. Others see a little inflation as a good thing, expecting it to subside when the Middle East returns to stability and food prices calm down. 
 
The idea that the west is still operating well below capacity so we need not worry about goods price inflation, does not reflect reality. There is a lot of inflation in the global supply chain. Manufacturing worldwide is quite short of capacity for raw materials and components. High demand in Asia does have an impact on prices and activity levels in the USA and Europe. We should not expect an automatic dampening effect from the fact that the west is still below peak levels of overall GDP.
 
The worry is that commodity and emerging market inflation will influence inflation expectations in the west and lead to bigger pay demands. All the time the west retains a stressed banking system, and all the time the public sector is trying to control its spending, there will be forces tending the other way on pay, whatever the popular view on the likely rate of future price increases.  
 
The US and Uk have been relaxed about seeing their currencies fall, which is in itself inflationary. There is also a wish in both jurisdictions to allow a bit more money and credit creation to fuel recovery. The European Central Bank is more likely to want to restrain excess, with the German influence being felt in favour of higher rates and stricter control of inflation. 
 
Meanwhile, on the periphery of Euroland, Greece and Spain have experienced downgrades in their government bond ratings this week. The cost of government borrowing for Ireland, Greece, Spain and Portugal has edged upwards again to levels similar to those around the time of the last crisis in the autumn of 2010.
 
None of this is a great outlook for government bonds.  The US and Uk both have large borrowing requirements. Peripheral Euroland also need to borrow large sums. Against a background of rising inflation and worries about rising interest rates, it is not a good time to hold longer term bonds. Bond portfolios where they are needed should be taken to shorter duration, avoiding exposed sovereign debt. We have done this for our clients, where appropriate.