Rising prices and rising interest rates
March 15th, 2011
As 2011 dawned I wrote that it would be a year of inflation worries and rising interest rates. Neither of those features is great news for share investors. Risk assets were no longer cheap. Despite that the markets greeted the New Year with an enthusiasm for risk. Investors wanted more in shares, anticipating more growth, higher profits and other good news.
A couple of months on, and the passion for risk is cooling a bit. The problem with liking risk is you may end up with the risks you do not want. People only like risk when they think the serious risks have gone away. It is usually wise to look through the mood, and ask what is really going on?
It is a story of emerging market led inflationary pressures, probably fuelled in part by the large number of dollars the US is creating as part of its stimulus package. Inflation is around 9% in India, 6% in Brazil and 5% in China. Food price inflation is in double digits, causing real damage to the budgets of the poor and leading governments like China and India to offer subsidies, increases in minimum wages and other palliatives.
The inflation is beginning to spill into the advanced economies as well. There is substantial pent up inflation in the supply chains of leading industries. Many companies are seeking to pass on increases in energy and commodity prices. There is a shortage of certain bought in components and intermediate goods, leading to further upwards pressure on prices. In the UK, which has undertaken its own quantitative easing programme and devaluation, RPI inflation has hit 5.1%. Even in the US and Germany there are signs of inflation stirring from the very low levels it hit during the intense Credit Crunch of 2008-9.
The interest rate and monetary response to rising prices has been patchy. Brazil already has posted interest rates above 11%. Because it offers such an attractive real rate of return on deposits, it has had to put in capital controls as well. China has taken her one year lending rate up to 6%, and Indian rates have belatedly reached 6.5%. Australia is the leader of the rising rates pack for the advanced world, with an official rate of 4.75%. UK rates remain stuck at 0.5%, with US and Euroland rates also stable and low.
As if inflation and rising rates was not enough to worry about, the world has also been gripped by the contemporaneous Middle Eastern revolutions. These may produce a better mixture of governments than the ones they displace, in due course. Meanwhile markets worry about how much damage will be done to world activity, what might emerge by way of new governments, and above all what it might do to the oil price. If the oil price goes too high and stays there too long it will intensify the pressures seeking to slow down the world economy. It makes inflation worse, which could force higher rates.
So far the prognosis is for China to succeed in slowing her economy enough to curb price rises, without overdoing the monetary stringency. The World Bank predicts Chinese growth of 8.7% this year after 10% last year. The Chinese government has cut its longer term growth forecast to an average of 7% a year for the next five years. They have in the past underestimated it. India expects continued rapid growth of around 9%, which implies continuing inflation.
If oil output is not damaged much by political events, the world economy should muddle through 2011. During the course of it we could reach the peak of Chinese interest rates and monetary tightening, probably at the point where the west late in the day starts raising rates. By the year end Asia could be looking better, and fears could be growing of a poor balance of inflation and low growth in the west, as the west struggles with past debts, imported inflation and rising rates.
If the revolutions spread to larger countries and major oil producers the initial market reaction will be every negative, whatever might eventually materialise by way of new and different governments.
As published in Investment Week
