By Joachim Fels Inflation expectations are currently very low, but history teaches us caution. Investors believe the benign low-environment will prevail for many years to come, as evidenced by survey-based and market-based inflation expectations. We have scrutinized 187 years of consumer price data for the US, the UK and Germany and drawn three conclusions: Low inflation usually doesn't last. Since 1820, periods of exceptionally low inflation have usually been followed by periods of high inflation. Episodes of high inflation occur typically, but not exclusively, around military conflicts. Inflation has gone global. Inflation has become more synchronized across countries over time, probably reflecting increasing globalization. As we've argued elsewhere, global factors have become more important on determining national inflation rates, especially over the past decade. One-way risk to prices. Since the anchor of the gold standard has been lost, the price level has had only one direction: up. Deflation is virtually ruled out in our paper currency system, and risks to prices are almost entirely on the upside. This is because central banks have become very averse to deflation, and because they usually don't correct for upside one-off surprises for inflation. Market Implications: With inflation expectations currently very low, and with 187 years of data teaching caution, buying protection against future inflationary surprises makes sense, in my view. By Richard Berner Regional differences are the key story: Fears of a pickup in global inflation are on the rise. Small wonder: Oil, food, gold and other commodity prices are soaring, and the dollar is weakening. I think those fears are overblown: Inflation risks are regional, not global. They are highest in some booming emerging-market economies. In contrast, in several larger industrial economies, underlying inflation has peaked and likely will edge lower. Analytics: Regional inflation risks depend more on local factors than on common global ones. Easy money and strong asset markets are fueling growth and inflation in India, Russia, the Middle East, and Asia excluding Japan. In contrast, slower growth is increasing slack in the US and will do so in the UK, and inflation expectations are falling. Stronger currencies and monetary restraint are damping inflation in Canada and Australia. Inflation trades: Uncertainty and reflationary policies are driving some traditional inflation gauges higher. Thus, investors should continue to bet on higher volatility, steeper yield curves, a weaker dollar, and rising commodity prices. The uptrend in Asian currencies will likely continue, especially where inflation threatens. Risks: Four risks worry me: The pace of the dollar decline could intensify, and the G7's efforts to push for a faster appreciation of the CNY could unsettle investors. Third, the combination of these developments may boost inflation expectations. Finally, if the US economy continues to weaken, the threat of protectionism will escalate, which would push up inflation and undermine growth. How Stretched? October 29, 2007 By Malcolm Wood Asia-Pacific ex-Japan valuations are at top-decile levels. However, adjusted for interest rates and returns, valuations are still well below 1993-94 peak levels, and fundamentally the outlook for Asia is far stronger than at that time. We believe current premium valuations are sustainable for the foreseeable future, and argue that fundamentals and liquidity conditions could drive valuations even higher. The key risks to this view are an oil price shock, a US snapback, and China overheating. Four reasons the 1993 boom proved unsustainable: Global liquidity conditions tightened abruptly; US growth accelerated, narrowing the growth gap; TMT emerged as an alternative growth sector; and Asia failed to deliver stronger returns. Today, the Fed is easing, US growth is sluggish, and Asian returns are at near-record levels. Asia is far better positioned today than in 1993: Asia growth appears robust, fundamentals are strong (record external balances, low ex-food inflation, record banking system liquidity, low rates, low levels of leverage, and strong returns), and earnings revisions are strong, while estimates appear undemanding. Capital flows are structurally changing in Asia's favour: Sovereign Wealth Funds, China QDII and QDRI outflows, and G7 international investment will all favour Asia. Portfolio implications: The pace of the rally has begun to slow, but we would be a buyer on dips, seeing double-digit returns on a 6-12 month horizon. We continue to prefer domestic-focused sectors, and China, Hong Kong and Singapore
