With February data confirming that the global economic recovery is largely back on track, we raised our scores across the board for recovery or the inflationary growth scenario. But this is still very much an industrial-led recovery as domestic consumption data remains lacklustre, even in economies such as Germany where growth is practically booming.
Despite disappointing news on the inflation front, it appears the equity market does not completely believe in the inflationary threat. Even after the recent sell-off, bonds are only discounting an inflation rate in the US of just about 2.4 per cent.
Our worry is that the majority of governments are looking through all the exceptional factors – such as food and oil prices – and discounting them as an exogenous problem that their own policy response cannot deal with.
As world monetary policy continues to effectively accommodate the significant inflationary pressures, there is a risk that we could be at a critical point where central bankers are about to commit a major policy error.
The UK is a prime example of a central bank not doing enough to tackle inflation. There is a growing fear that the Bank of England is risking a major loss in confidence over its continued failure to meet its inflation target.
If the Government’s spending cuts do not deliver a strong enough deflationary drag later this year, the Bank of England could be forced to tighten policy aggressively.
Coupled with worries about rising inflationary pressure, we are now seeing events in the Middle East which have served to push oil prices up to around $115 per barrel. If stresses continue to build and oil prices rise through $120 per barrel, we could see a very material impact on con-sumer spending in the West and a relapse into recession.
Exploring the most appropriate way to diversify and manage assets during this volatile time, Barings has upgraded government bonds and index-linked bonds to neutral following a meaningful rise in yields on conventionals to 3.4 per cent whiles US Tips hit 1.4 per cent at the end of February, before rallying to 1.1 per cent.
Equities still look fair value, although they are reliant on continued earnings.
Another important change to our multi-asset portfolios has been the downgrade of gold to neutral.
In our view, one of the attractions of gold for big investors like pension funds and sovereign wealth funds is that it has generally been uncorrelated to riskier financial assets such as equities. In 2008, when the equity market bottomed out, gold returned 4 per cent compared with a fall of 30 per cent in UK equities and a 40 per cent decline in global equities over the same period.
We invested our multi-asset portfolios in gold at the right time and benefited both from the rising price and the diversification value it offered.
But since 2010, gold has started to lose its shine as a risk diversifier and has begun to correlate with risk assets, such as equities. Rising inflation has brought forward the spectre of higher interest rates posing a further threat. So, as gold begins to lose its glimmer, we believe there is an opportunity to shift to other assets with better risk reduction qualities, such as inflation-linked bonds, agriculture, property and even cash.
Percival Stanion is head of asset allocation at Baring Asset Management