A U-turn

The November US inflation data, which was substantially higher than expected, has aroused market fears that the US economy could be on the verge of an upward inflationary spiral.

Louis Niemand, a market and economic research economist at Investment Solutions, says thatthisis a 180-degree turn from as March 2004, when the threat of deflation - a sustainable period of falling prices - was the main concern.

(This inflation data showed that consumer prices rose 3.5%, up from 2.5% for the year ending September, mainly as a result of rising prices for oil and base metals such as iron, copper and aluminium. US Core CPI, which excludes oil and volatile food prices, rose from 2% to 2.2%.)

Niemand said inflation is a primary driver of US interest rates, which not only directly affect macroeconomic growth, but influence equity and bond market valuations and performances in the US and across the world.

Therefore, correctly identifying US inflation trends is vitally important. "The monthly inflation releases attract a lot of attention, but the importance of longer-term trends is sometimes overlooked,' he said.

The key question is: Has the US economy, shifted from being in danger of falling into deflation, to being caught in an upward inflationary spiral?

In the US, overall inflation on all major CPI components has declined from the highs of the 1970s and early 1980s, with headline CPI settling at around 2.5% since 2000.

However, except for the Durable Goods component, affected by mainly external factors, none of the other underlying components has shown signs of sustained deflation in recent years.

After "scaring" most market analysts and economic policy makers in 2002 by dropping to as low as 1.1%, inflation has trickled higher to around 3%.

"Of importance to investors is that asset classes tend to react differently in different inflationary and interest-rate environments.

“A look at the correlation between inflation and interest rates and the performance of the three major asset classes -- US equities, bonds and cash -- during the last 30 years shows that historically there has been only a marginal negative correlation between inflation and equity market performance.

“Of more importance is that equity valuations (P:E ratios) are highly negatively correlated to interest rates and inflation. Therefore, during periods of high -- and rising -- inflation, interest rates tend to rise and P:E multiples tend to decline.

The performance of bonds shows no correlation with inflation, but is highly negatively correlated to interest rates, while cash tends to be positively correlated to inflation and interest rates," explained Niemand.

"By implication, if the US economy were to fall into a period of deflation, interest rates would likely decline, resulting in bonds performing strongly and nominal returns on cash continuing to diminish.

“The effect on equities would depend on how the economy in general was holding up. If sustained deflation resulted in a substantial slowdown in consumer expenditure and overall economic activity, equities would be highly unlikely to provide strong returns.

"On the other hand, if inflationary pressures escalated in the US, interest rates would likely rise, negative effecting bond returns, while nominal returns on cash would increase.

“In this scenario, the sustainability of economic activity within the rising interest-rate environment would drive equity returns."

Niemand said while concerns have diminished considerably during the last six months, it is too soon to say that the spectre of deflation has disappeared, or that the rise in inflation is the beginning of a sustained upward trend.

“Current inflationary pressure is mainly a result of external factors such as the oil price, which has declined 18% since the end of October.

"The investment implications of this are that investors need to be cautious and not take an all-or-nothing stance on asset allocation based on their inflation/deflation view.

“The performance of different asset classes could vary considerably in different inflation scenarios.

Diversification remains key considering the uncertainty of US inflationary trends," said Niemand.