With all the talk of double-dip recessions, Japan style deflation and the real possibility of further quantative easing (ie: money printing), I did a double take when I saw an article in The Telegraph today referring to research by Policy Exchange think tank that points to the possibility of base rates at 8% and inflation at 10% within the next two years.

Personally, I think that is very unlikely and, indeed, it was only last month that the Ernst & Young ITEM Club predicted that UK base rates may have to stay at historic lows till 2014. You can see both articles through The Telegraph below:

Interest rates may hit 8% in two years time
Interest rates will stay low till 2014

These differences of opinion are becoming more and more common and, unless you have a very strong opinion either way (or have a reliable crystal ball), I am pointing people increasingly in the direction of absolute return vehicles. To use an analogy, traditional equity funds can be likened to F1 cars; when the road is smooth and straight, these are the best vehicles to be in. When the ground is a little more uneven, however, F1 cars really don’t perform very well. Instead, an absolute return fund is akin to a rally car; pretty good on tarmac and off road alike. So the theory goes, no matter what is coming up on the road, an absolute return fund ought to perform. An anonymous example of what I mean is provided below.

Absolute return example

As this shows, by maintaining a diversified spread of assets and only holding those assets that you think will make a profit (easier said than done), a relatively consistent return is possible.

As you may have seen on the news, wheat prices are rising fast in reaction to drought and brush fires in Russia which has cut back production. Russia has also recently taken the unprecedented step of banning grain exports, at least until the end of the year.

Where Russia is traditionally one of the largest producers of wheat, it is hardly surprising to see that prices have inflated and that will translate to a hike in cost of your daily breakfast.

So what does this mean for inflation – and your investments?

With consumer price index inflation (CPI) already well above the Bank of England’s target of 2% and with these further inflationary forces in the pipeline, it would be easy to assume that the Bank of England will look to raise interest rates to dampen things down.

But I suspect nothing will happen.

It comes down to understanding the source of the inflation. The sort of price inflation that is worrisome for policymakers is inflation driven by wages. If there is excess demand for goods over supply, prices will rise to meet that demand. In turn, workers will demand higher wages to compensate, and then companies raise prices again to make up for the higher wage bill. This in turn leads to demands for higher wages again and, pretty soon, you get into a vicious circle.

That isn’t the sort of inflation that we have at the moment. Average wage growth has actually slowed in recent months and, hardly surprising, as unemployment is so high.

The inflation we have at the moment is being driven by a hike in raw material costs such as energy and food. Significantly, these are all the things we need and find hard to cut back on. So, if you can’t cut back on these essentials and your wages aren’t rising as fast as your costs, that means you have to cut back on other things. So in this case, rising costs act a bit like a tax. A further drag on the economy.

So, for the time being, I suspect the Bank of England will continue to remain more worried about another slump rather than an inflationary spiral and that means that interest rates ought to remain low for the foreseeable future.

How to make a profit?
Low interest rates will continue to encourage investors to seek out yield elsewhere and that should be generally supportive of markets. However, in terms of profiting directly from growing demand for food, how should you go about that?

Personally, I am wary about investing into commodities directly. The volatility is too great and high commodity prices almost automatically create the conditions for their own destruction – people spot the opportunity to profit, so they plant more, they work on more efficient ways to grow things, they turn more land over to agriculture. In turn, this increases supply and prices drop.

A much more effective and relatively safer way is to invest in the companies that will make money by helping us to meet this demand. There are plenty of funds in this sector that will manage the commodity mix for you, retreat into cash when the time is right and use appropriate hedging to limit price volatility.

Global Overview

Sovereign debt has created a large cloud of uncertainty over world markets during the course of 2010 and it promises to be an important factor in market performance during the rest of 2010 and beyond. The concerns over sovereign creditworthiness have seen an increase in risk aversion, with Government bonds in the US, Japan and Germany rallying.

We remain concerned that global recovery may well disappoint during the remainder of 2010 and into 2011. The massive amount of deleveraging that is taking place coupled with the demise of quantitative easing will mean that high levels of unemployment are maintained for some time and will be accompanied with lower working hours and reduced incomes due to pay freezes. This coupled with the austerity measures now being implemented in many countries mean we expect low/no growth, combined with low inflation or even deflation. In addition we foresee a continuation of the market volatility that has been witnessed during the first half of 2010. The divergence between countries and sectors in 2010 will mean that careful selection by managers will be crucial to returns. The disparity of returns between countries will bring with it a currency risk via increased volatility.

Consumer spending is currently more buoyant in emerging economies, China’s retail sales are still increasing but the picture is less healthy in developed economies, until global consumer spending and business investment becomes more consistent across regions the recovery appears less sustainable. Tighter fiscal policies and reduced credit will make it more difficult for developed countries to grow whilst countries such as China are focusing on infrastructure developments. The Chinese however, are nervous about the global economy and inflationary pressures at home, policymakers are conscious of asset price bubbles being created in certain sectors, they will need to change from a heavily export driven economy to a more domestically driven economy as part of their rebalancing process.

As companies and stock markets become more global in their composition and exposure it will be important to ascertain the level of returns derived from overseas compared to potentially slower domestic growth for those in Western economies. It seems that the second half of 2010 and beyond could be a time of opportunity, but one that certainly comes with considerable risk.

US

Valuations in the US appear relatively attractive as more companies return to profitability and easier monetary and fiscal policies are supportive in the US. Whether this is maintained once the impact of Government support is withdrawn remains to be seen. One of the major threats is the unemployment rate at 10%, largely a result of cut backs in the construction, leisure and manufacturing sectors. Data has been conflicting during the first half of 2010 and house sales have recently declined in quite sharp manner over 30% in May, far more than estimated and millions of homes face foreclosure that until now has been postponed meaning that the US property market is still in turmoil. The Fed is likely to focus on the labour market before deciding on the exact timing of an exit strategy. However, sales figures have just increased at the fastest pace in 4 years indicating that consumers have overcome unemployment fears. We remain cautious about investment bearing in mind the volatility and the yet to be seen effects of the withdrawal of Government stimulus but the opportunities for investment into large cap, internationally diversified US companies paying an attractive dividend are one’s that we will be watching for as the rest of the year unfolds.

UK

The arrival of the coalition Government has been relatively smooth and the measures unveiled in June as to how they propose to cut the deficit have been welcomed by markets and both sterling and Government Gilts have strengthened as a result. Unemployment is a key issue the UK and whilst rates didn’t increase as much as once feared due to improved corporate finance, unemployment and consumer spending remain two significant threats to an improvement in the UK economy. It’s going to be critical how the government achieves a correction of the financial situation whilst being supportive of economic recovery and high unemployment around the 8% level is likely to be the norm for a prolonged period. Whilst low interest rates are supportive, rising food and energy prices coupled with unemployment will make it difficult for policymakers to strike the right balance. As spending from fiscal measures end and the austerity measures take effect the end of 2010 and 2011 look like producing low growth at best. Once again, we will be looking for large cap, internationally diversified companies paying an attractive dividend into which to invest on bad days.

Europe

Sovereign Debt has dominated the Euro zone during 2010 and has raised considerable alarm over not only individual countries abilities to service their debt levels but also concerns over the euro zone as a whole. There has even been talk of a two speed euro. The Germans have underwritten a massive E720bn support package for the euro zone and that in itself has caused large political fallout in Germany where the measures are unpopular and where Angela Merkel has now lost her majority in the upper house. This massive support package also failed to stem concerns about the euro and both Greece and Spain had their debt levels downgraded and Portugal’s has been placed under review. As a result the Euro has weakened considerably with speculation that parity with the Dollar will occur before the year is concluded. On the flip side this has strengthened export competitiveness. The Sovereign debt issues combined with the weakening euro leave the euro zone in a volatile place with a number of different conclusions. The unilateral imposition of a ban on short selling by the Germans has only confirmed in some investor’s minds that the euro zone conflict is intensifying. Once again this level of volatility is of concern to us and for the time being we are happy to sit on the sidelines and watch the drama unfold.

Japan

Japan was the laggard of the developed markets in 2009 as a result of a strong yen and an export driven economy, add to this some disappointing domestic data and the outlook for Japan is far from optimistic. Although the financial sector has been stronger than many Western counterparts, profit margins are a concern and the policy responses have been nowhere near as supportive as in other countries. Japan desperately needs to see the return of inflation, reducing the value of the yen and therefore improving the potential for exports. The country has a number of structural weaknesses such as a declining workforce and aging population and the increasing government debt is likely to attract the unwelcome attention of investors if nothing is done to remedy this ailing economy.

However, Japan is no longer the ‘ugliest belle of the ball’ economic news this year has been mixed but mainly positive. Exports have remained strong, up over 30% in May Year on year for example albeit these numbers should fall during the rest of the year as the base is wider. GDP growth should be in the region of 2.5% to March 2011 and 2% to March 2012. Negative influences are the remaining strength of the Yen and the concerns over the euro zone, which has since a move to risk aversion. On the positive side valuations are very low and whilst there will be volatility there is scope in our opinion for growth in Japan and in particular in the small to medium cap area that is more domestically focused.

Asia

The Chinese have recently started to look more fearful of the recent expansion of credit and inflation concerns seem to be firmly on the agenda. Those economies benefiting from strong Chinese growth such as Hong Kong should offer attractive rewards. Consumption hasn’t been hit as hard in Asia where investors usually have higher savings and low levels of debt. Increasing levels of domestic consumption reducing the reliance on exports will prove positive for emerging economies. However, bubbles could be forming in some markets and valuations may be stretched so there is a risk to investors to ensure they are selective when evaluating the potential for further growth in this region. Whilst inflation and interest rate increases are a concern for the region policy, fiscal tightening by the Chinese could produce volatility in global asset prices due to their influence on global demand and consequently more of a far reaching effect.

Property

With our belief that we are in a low/no growth environment combined with low/no inflation means that yield will be a key driver in obtaining returns during this post credit crisis/post government stimulus era. As a result we are positive toward high quality commercial property. There is still good demand for this type of asset and we believe it will continue to offer attractive yields based upon solid foundations and we currently hold weighting to some UK REITS and believe that this asset holds potential for further growth.

Whilst we believe that property is still overvalued in Hong Kong & China we are looking for opportunities in this asset class should there be a setback in valuations.

Summary

The world economy remains in a very fragile state and caution is the watchword as 2010 progresses and we then enter 2011. We believe growth will slow more than people are expecting and that inflation will also be very low. As a result we are keen to examine opportunities that exist where an attractive yield is matched to an asset with genuine value.

Source : Miton Asset Management