Inflation could become new top enemy

Inflation threatens to supersede the credit crisis as investors' biggest enemy later this year as fears of a deep economic downturn recede and commodity prices show no signs of easing.

Growing relief that the global economy has so far escaped the worst case scenario from the eight-month-old credit crisis has stabilised financial markets. World stocks, as measured by MSCI, are hitting three-month highs and pulling the dollar off its March record low.DXY against major peers.

Many central banks, faced with the twin problem of the credit crisis and rising prices, have cut interest rates to ease the flow of credit, leaving inflation issues for tomorrow.

However, the relentless surge in resource prices from oil to rice and the resilience of emerging economies risks are turning inflation into the bigger worry for policymakers and asset markets.

Japanese inflation, which hit a decade-high in March triggering one of the biggest ever sell-offs in yen bonds on Friday, is a case in point.

"If the global economy has struggled out of the frying pan of the credit crunch, it seems destined to fall into the fire of high inflation ... High inflation is cruel to the owner of financial assets," said Tim Bond, head of global asset allocation at Barclays Capital.

"Equity markets will rally for a limited period of time on belief that weakness in earnings will be short-lived. Moving into next year, you will see markets come off on the inflation story. Investors who see some of the rise in earnings being driven by inflation generally take the view that's not sustainable."

Mr Bond says during the last inflation crisis of 1970-1980, only a handful of asset classes gave positive real returns, including banks, basic resources, energy and industrial goods equity sectors, physical oil and physical commodities.

During that decade, the S&P 500 index's price earnings ratio fell as low as seven from a high of around 18.

Although the picture is distorted this time by the weakness of financial firms, Mr Bond estimates the P/E ratio could fall to around 13 if US inflation expectations fire up.

Mr Bond says default rates would have difficulty improving because inflation could raise nominal interest rates.