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24 May 2011

Neil Dwane, CIO Europe at RCM, a company of Allianz Global Investors, gives his latest outlook: “Japan continues to feel the repercussion of February’s earthquake, and resulting events have had not only an emotional but also industrial impact on the Japanese economy, at a time when the country faces an urgent need to restructure its economy and rise to the demographic challenge of an ageing population. Their situation highlights the wider theme of potential slowing of economic growth in the developed world as we look forward into Q3 and Q4 of 2011. In the UK we are already experiencing a very weak GDP growth rate, below the forecasts needed to pay down the budget deficit. In Continental Europe, we can see that austerity is not good for economic growth with Greece, Ireland and Portugal all slowing sharply. Even in Spain, which many would have considered “safe”, retail sales year-on year fell nearly 12% in the first quarter. Slow economic growth to rising inflation “This slowing economic growth is even more pronounced in emerging markets, resulting in a prevalence of rising global inflation trends. A confluence of unusual and unexpected weather events is leading to food scarcity which, in turn, is pushing food commodity prices to very high levels. A continuation of erratic weather patterns, coupled with the current lowest food stocks for 50 years may see a global race for food as grain exporting countries are quick to stop exports in the face of poor harvests. Those countries in the emerging world that are most exposed to food inflation are India and China. Inside their retail systems food inflation is at 8-10% which poses a real issue to the man in the street. In Europe we spend around 10% of our wages on food, in emerging markets they spend closer to 50%. Therefore food price inflation in the emerging world is a serious problem and can threaten spending severely. Inflation is a tale of two worlds “Inflation is therefore a tale of two worlds. For developed economies such as Japan and America this inflation is transitory; they don’t look at inflation in terms of what consumers pay but in terms of unemployment which remains high, reflecting slack in the economy. In Germany, we have seen unemployment tumbling as it has benefitted from the growth in the emerging world. This has resulted in the ECB watching very closely for inflationary pressures in Germany and ignoring the potential threat of Portuguese or Greek deflation. With concerns over German growth the ECB should implement another base rate rise which we expect to reach around 2% in 18 months time. This is contrary to measures needed in the economies of Spain, Ireland, Greece and Portugal. “The emerging world is undertaking the classic response by raising interest rates to slow down their economies to reduce this inflation. We are seeing record levels of imported inflation from the likes of China and other manufacturing nations which has led to a double whammy for the US, with a weakened dollar and imported inflation having a detrimental effect on the US consumer while a weak dollar will mean that China and other emerging markets have to restructure away from the dollar. Asset allocation considerations and financial repression “When inflation sits between 2% and 6% equities remain the supreme hedge against this. Anything below 2% risks the threat of deflation for all assets while over 6%, equities lose their effectiveness and ability to grow. What we do know is that bonds yielding 3.5% offer little protection so with most Europeans 90% invested in bonds this seems an unwise move. Inside equity markets, Asia and Europe are showing attractive valuations on both a long and short term basis. In the US you have to find strongly appreciating assets as you are investing in a weakening dollar which means assets are constantly losing value. “It is likely that central banks will begin to employ financial repression, where interest rates are engineered to remain under inflation so that the longer term debt they issue or hold falls aggressively in real terms. This requires inflation to remain between 4% and 6%, but is one of the best ways for governments to get rid of their debt. This plan is only possible for the likes of the US or the UK and is impossible for Greece or Portugal. It seems to me that whether central banks use inflation to reduce debt or restructure, bond holders will have to bear the brunt. How many external investors will buy US treasuries, UK gilts or Japanese bonds if these governments appear to be undertaking these policies?” Source of data RCM May 2011 Past performance is not a reliable indicator of future performance. You should not make any assumptions on the future on the basis of performance information. The value of an investment and the income from it can fall as well as rise as a result of market and currency fluctuations and you may not get back the amount originally invested. The information contained herein including any expression of opinion is for information purposes only and is given on the understanding that it is not a recommendation and anyone who acts on it, or changes their opinion thereon, does so entirely at their own risk. The opinions expressed are based on information which we believe to be accurate and reliable, however, these opinions may change without notice.

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