Analysis & Comment:
Previous 'The Monthly Banker'
The Monthly Banker: 1 March 2011
“The world is full of people whose notion of a satisfactory future is, in fact, a return to the idealised past.”
Robertson Davies, "A Voice from the Attic", 1960
A year ago, the venerable Bank of England expected CPI figures to nosedive by the year end (see Figure 1). Based on this projection, the Bank kept interest rates low and held the £200 billion QE program on track. Some punters, seeing the QE2.0 in the States, even speculated that BoE may expand the QE here.
Making predictions, unfortunately, is a hazardous business, as the Bank of England just found out. Not only did the expected inflation trend failed to materialize, it actually went the opposite way. Inflation surged because of rising food and energy prices, propelled by a strong global economic recovery and accelerating wage inflation in big manufacturing countries like China.
Having missed the 2% target for most of the 2010, the BoE remains adamant the this level will be met, as its recent Inflation Report shows (see Figure 2). Meanwhile, the governor King hit back at the possibility of a rate hike this summer. Will BoE be right? Being caught on the wrong side of the inflation trend is already fostering splits in the MPC. The stakes are huge. For BoE, its credibility is on the line; for investors, billions are wagered on the inflation trend.
We do not think there will be a clear winner for the time being. Why? Excess volatililty.
(1) Massive liquidity injection from the Fed, which is fuelling rank speculation from equities - especially small cap stocks - to commodities. When prices accelerate upwards like they did in several commodities this year, it can be very destabilizing for speculators and authorities alike. Forecasting becomes harder.
(2) Accelerating monetary tightening in key Asian countries. This is promoting stronger Asian currencies and unpredictable economic developments. Will the Chinese economy, for example, tip into a recession should the PBoC hike interest rates further in 2011? If so, what will be the repercussions for the rest of the world?
(3) Geopolitical tensions in the Middle East, leading to wild swings in oil prices. The series of uprisings across the region took all by surprise; its end will, too, be a coup de theatre.
Because of these huge cross-currents, it is virtually possible to map out the inflation trend in the UK this year. There are just too many uncertainties that could derail forecasts. Still, we hazard a guess. Our baseline view is that inflation may increase higher than expected because of rising energy costs. While inflation may weaken later, the 2% level will prove elusive this year. Inflation is expected to stay persistently above target.
Facing a barrage of unexpected risks, what should investors do? Our advice is simple: Stay nimble by amassing cash and liquidity. Wild swings in prices will present opportunities to buy stocks on the ‘cheap’. Having additional buying power is an advantage. Also, a trading opportunity may appear in government bonds in 2011 should the yields go up further. Regarding gold, we are of two minds about this commodity right now. On one hand, we like gold’s relative safety due to the possibility of a sovereign default. On the other hand, rising interest rates work against the non-yielding yellow metal. Therefore, we are disinclined to chase the metal higher for now, preferring to accumulate on the lows.
Overall, we are expecting a volatile 2011, perhaps choppier than 2010. Yogi Berra’s insight “the future ain’t what it used to be” perhaps captures our thinking right now.