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Investment Brief: INFLATION

The issue of inflation continues to trouble investment decision-making. Two analysts outline their opposing arguments. Interviews by Lee Jones

’UK will weather the tightening and grow’


The bull
Ian Harwood, chief economist, Evolution Securities

We are in a promising situation. People have not fully acknowledged what has gone right so far – we have had an increasingly solid global recovery, both in the US and elsewhere. The last year has been a surprise for the bears because things have recovered in a V-shaped fashion.

This can be illustrated in the corporate sector and with company profits. I take the view, which is pretty atypical for economists (a fact that has always been a puzzle to me), that what happens to profits tends to determine where a market economy goes.

If companies are doing well, they tend to invest and they tend to hire and that boosts consumer spending, which you can see in the US right now. In the UK, corporate profits are doing well and that will have significant follow-through effects to the rest of the economy.

Right now, markets are worried. People think any signs of recovery are down to one-off actions, namely the inventory cycle and government stimuli. Both those factors have played a role but I think many have ignored the fact that corporate behaviour is becoming an increasingly important player in generating recovery. We will see, as stimulus is taken away and as inventory cycles run down, that it will be the corporates that will be helping to carry the global recovery forward.

The big public and private debts will be a restraint because companies and households will not want to build up debt but it is easy to exaggerate this. Companies always cut debt in a downturn and they were not as over-extended as some people suggest.

Households did get overextended, particularly in the US, UK and Spain, so we will not see a consumer boom but we have seen a consumer recovery and that has confounded the bears. Savings ratios are at about 4 per cent, jobs are growing and people are spending again.

Bears have been proved wrong and will continue to be because there is no automatic link between debt and spending, although many people assume there is.

Some fiscal packages are going to be very tough and they are not good news for the likes of Greece and Spain but they are not massive economies and if you look at Germany, it is going like a train.

There are question marks over the success of the Budget in the UK because there is doubt whether growth will be as robust as the Government predicts and whether it can push through the spending cuts but I do not believe this fiscal tightening will derail the UK economy.

In 1981, the UK’s top 364 economists wrote to The Times saying the impending Budget would force the UK economy into depression but they could not have been more wrong – there was an ongoing recovery straight from that Budget.

Right now profits are up in British business and if the global backdrop stays robust, then UK exporters will benefit.

I really do not see a reason why we need to shout from the rooftops that the UK is set for a double dip. I think it will weather the tightening and it will grow.

’We are in the midst of a depression’


The bear
Jeremy Batstone-Carr, director of private client research, Charles Stanley

I think a time of austerity is here and investors should be taking a flight to safety because the bottom line is debt, masses and masses of debt.

Global total debt – public, private, household and government – is at around $222.5 trillion, or 362 per cent of global GDP. The inevitable consequence of addressing this debt is a prolonged period of deflation and deleverage.

The Nobel-prize-winning US economist Paul Krugman says we are currently in the midst of a third depression and I agree. I think depressionary conditions set in around 2000 and if you look back over history, depressions can take 15 years, so we are about two-thirds of the way through this.

The US response so far has been to keep stimulating the economy because it is in a liquidity trap but you can only do this if the bond markets support you, otherwise yields would blow out and you would be in default territory.

The US is in that fortunate circumstance where it has ongoing demand for its treasuries in spite of such circumstances, which no other sovereignty would have.

I think the UK response is the right one and before too long the US will have to start hunkering down with us as well.

As a result, I am bearish on equities because the Q2 2010 reporting season will be characterised with a reappraisal on earnings’ growth expectations for 2011.

If we are in an environment of slowing economic activity, as we must be with the belt-tightening in most of the Western industrialised nations, then we are not going to get the 30 per cent earnings’ growth that people are envisaging for 2011.

Earnings’ growth is already close to peak operating margins, so 30 per cent growth would be unprecedented.

It is now all about capital preservation instead of capital appreciation. You hunker down and you try to ride out the storm.

There are a number of strategies that investors can employ to implement this. The first is to look at income-orientated equities, that is companies with a good track record of growing dividends through thick and thin. That does not necessarily mean looking for high yield, rather looking for firms with progressive dividend policies.

Before things get better, the debt to GDP ratios have to come under control and it will be very unpleasant.

It may mean tens of millions of unemployed workers in the West will pay for this. It is a pretty dire outlook but we have to go through that pain otherwise the longer we defer the pain, the worse things will be.


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