There are often policy decisions that politicians want to kick into the long grass – in Britain it happens under the guise of a ‘Parliamentary inquiry’ – and nearly every country has its own equivalent. Sometimes the issue can safely sit on the ‘To Do’ list of policies for another year, or for a successive government. But there are some issues which, left unaddressed, grow more dangerous by the day, as numbers compound, political positions become more entrenched and the room for manoeuvre narrows. This is undoubtedly the case today as we watch a variety of interested parties wrestle with the thorny questions of first, how to refinance insolvent European countries without causing a pan-European banking crisis and second, how to agree on a strategy to address the US fiscal deficit.
These are two of the ‘big issues’ which stalk capital markets and have the capacity to disrupt global economic recovery, which currently is broadly tracking the positive trajectory that we envisaged in our 2011 Investment Outlook: Redrawing the Map. There have of course been some surprises in the make-up of growth since the year began. Emerging economies have suffered a setback from food- and oil-driven inflation pressures, while a re-stimulated US economy finally has a recovery that is spreading into the labour market.
Global growth has been sustained, but it is not sufficiently strong to dispel concerns about ‘stagflation’ in the West. The UK economy flat-lined during the six months from October to March and the US grew by a disappointing 0.4% in the first quarter, at a time when their CPI inflation rates are running at 4.5% and 3.2% respectively.
As is frequently observed, inflation is a debtor’s friend, and therefore currently the friend of most Western governments – and much safer than the alternative, deflation. In our view, a deficit reduction programme aided by, say, 3-4 % inflation (which, at 4%, equates to a real reduction in liabilities of 22% over five years ) is a more achievable fiscal adjustment route than the alternative that is currently being forced on peripheral Europe – nominal public sector wage cuts (which in Greece are close to 20%) and recession.
As outlined in the 2011 Investment Outlook, we expect the global recovery to remain centred on the new axis of growth in China, wider Asia and emerging markets in general, where we believe inflation will peak later this year. These markets still trade at a valuation discount to their developed peers, despite having faster-growing economies and higher returns on equity. The anticipated strengthening of local currencies is an additional source of potential returns.
With global recovery still underwritten by loose monetary policy, cheap money still has to find a home somewhere. Against this backdrop, it is right to be vigilant for ‘bubbles’, and it would be a mistake to assume a smooth ride ahead. Valuations and risk management remain central anchors to our investment decision-making.
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