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Multi-manager View

The spectre of inflation has reared its ugly head much sooner than many expected and created significant volatility across financial markets. This has been triggered by a material shift higher in global interest rate expectations.

The battle between interest rates and inflation is best seen in emerging market economies. At some points in January many EM equity markets were down by over 10 per cent.

For fast-growing industrialising nations, inflation is going to be a serious long-term issue. We are not sure the export-focused economies will be able to raise their export prices faster than the commodities they use to make them, which was the big issue behind their slump in 2008. In the short term, we remain slightly wary of EM equities and debt, although we are comfortable with the positions we hold. At some point in the first few months of this year we might be presented with an attractive opportunity to increase our EM weightings.

Inflation might be a bigger problem for the developed world, as some countries could suffer from the grim combination of debt-inspired low growth and high inflationary pressures. We think that such thoughts will be the pre-eminent driver for global financial markets in the coming months.

Amazingly, some commentators are now calling for four rate hikes in the UK this year, with the first coming in May; an extraordinary volte-face from the start of the year.

We are starting to see inflation appear in the corporate results season as some companies are beating sales targets but missing profits. This would agree with our primary concern for equities at the start of the year that rising commodity prices would start to hinder profit margins, which are already at record levels. Should this continue, inflation could create doubt about the sustainability of the equity bull market in the second half of this year. We have become more defensive and have taken significant steps to inflation-proof our portfolios.

Our preferred method remains global inflation-linked bonds. We believe, relative to the structurally expensive UK linkers market, there are attractive opportunities in global index-linked bond markets. They will give investors some decent inflation protection because of the nature of their inflation-linked pricing and coupons. This makes them much more attractive at this time than conventional government or corporate bonds.

We also feel high-quality global equities should be a decent way of inflation-proofing portfolios. We are more sceptical about the credentials of commodities. In fact, the growing great wall of passive money that has built in commodity markets could be one of the great threats for financial markets in the years ahead if sentiment changes.

Tom Becket is manager of the balanced managed fund of funds at PSigma


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