Pressure points
Share
Business investment would fall, hurting future profits. In the equity market, the valuation gap between bond yields and earnings yields (the inverse of the price/earnings ratio) has been a key buying signal in recent years but this would start to evaporate if interest rates staged a concerted rise. This would happen more quickly as earnings' expectations were cut back. As it happens, there are already signs that US earnings' growth is beginning to cool after years of double-digit growth.
Yet there is plenty of evidence to suggest inflationary pressure is containable, if for different reasons in different markets. The UK's monetary policy committee is firm in its belief that current pressure is temporary, as falling energy prices will start to feed through into year-on-year comparisons, helping headline inflation fall back towards the 2 per cent target. In the US, the Fed reckons inflation, although stubbornly high, will eventually start to recede, particularly if the labour market weakens and consumers start to curb spending. In China, double-digit GDP growth has yet to have much impact on inflation, given that there are few bottlenecks in the economy and productivity growth is at impressive levels. In Europe, a stronger labour market is feeding through into above-inflation wage settlements but even after seven rises in the current cycle, rates of 3.75 per cent are low, all the more so when set against strong expected earnings' growth by corporations.
We do not envisage inflation ballooning out of control. We have still not felt the full impact of the interest rate rises in the US and elsewhere while central bankers still have headroom before rates start to look high in real terms. Not that we will not get jitters in the months to come. A number of central bankers have pointed out that they expect the data to grow more volatile, particularly if energy prices remain unpredictable.
If inflation stays high in the shorter term, then bonds offer few attractions. In recent months, you would have lost money on gilts, even including income, hence our decision to let cash build up. This now makes up over 20 per cent of our Merlin income portfolio. Value will emerge in bonds once it becomes clear the interest rate cycle has peaked but that is not a call we would envisage having to make for a while. Equities offer a degree of inflation protection, so long as expectations remain contained. Much remains in the balance but equities still look the best place to be for now.
John Chatfeild-Roberts is head of the Jupiter independent funds team.
If you enjoyed this article, sign up here to receive daily email updates from Money Marketing and Follow @_moneymarketing
