Three months ago we sprang like a bathing belle from a birthday cake, proclaiming that the world was unequivocally in the thrall of inflationary forces, and that the investment mix - for mix it remains - should have the hallmarks of inflationary protection.  The purpose of this review is to explore this theme, both in the light of another three months passage of time, and in the complexities which surround an assessment of the value of money.  For years we have been warning against the dangers of deflation - why, one might ask, this 180 degree turn?

The key to its understanding is to know that inflation and deflation are both manifestations of monetary instability and their opposite is not each other, but monetary stability.  Imagine a rowing boat, rowed by a gentleman, heavy in hock.  When all goes well he sits in the middle of the boat and makes good progress.  But imagine, too, that he unwittingly moves the avoirdupois somewhat to the right of the boat.  The boat lurches to the right - but which way will our hero fall?  If he does nothing, over the right side he will go.  If he over-corrects and lunges to the left, he'll join the fishes on the left side of the boat.  Which way he goes is more a finesse than a polar opposite, and so it is with inflation.  Events are frighteningly deflationary at the moment - if nothing is done, then things will tip over into deflation.  But it is our contention that something will be done by the central banks and the efforts they make to save the economy from its travails will release inflation, and this is the dominant theme of the review.

We will turn in a moment to our assessment of what is going on in the world, but first let us declare a plague on both the houses in the current inflation/deflation debate.  The inflation camp is largely occupied by those who to a greater or lesser extent are optimistic about the outlook.  The credit crunch, they concede, was massively dislocative, and has had a dampening effect on the economy.  Growth has slowed, and may well slow further, but the dislocation is essentially behind us and we can look forward to better times.  Alas, the inflationists acknowledge, the world must get used to a higher cost of food, of energy and of other forms of materiel; no longer will Chinese goods be a driver for lower prices.  Inflation for them is the parrot on the shoulder of Captain Hook and his 3% growth per annum.  The deflationists will have none of this.  The credit-creation mechanism is broken they say, and 60 years of leverage must be reversed.  This is the mistral feared by the shepherd-economists: a wind which freezes asset values, economic endeavour and threatens the very stability of capitalism.  It is deflation which we must fear - and the excess demand for oil and other goods will soon wither away in the icy conditions.  The deflationists are (as described) spot-on, as far as they go - but we have often observed that inflation can be brought about in deflationary times by a compromise of the currency.  Paper currencies are not anchored to anything whose scarcity allows them to hold their value: trees grow a-plenty.  If Bernanke chooses to compromise the Dollar, then it will show itself in a rise in domestic prices.  This is the plan - for America.  It is an attempt to reproduce on an international stage the 'stagflation' of Britain in the 1970s.  Prices go up, interest rates stay low so that the over-borrowed are subsidised and the astute or lucky player who was in cash when the locusts appeared, finds that he is penalised by receiving less in interest payments than he loses in inflation.  In short, the lender is the one who subsidises the borrower.  This we articulated in our April review.  The last three months have reinforced the thought that Bernanke is set on this course.  But the European Central Bank and the Bank of England are not with him, and are indeed pulling in quite the opposite direction.  Why should this be so?  The twin fears of deflation and inflation rise up like a rock and a hard place at the moment.  Which course to steer is, it seems, dependent on the folk-memories and fears of the helmsman.  For helmsman Bernanke, the bogey-man is the 1930s depression in the United States, brought about by Central Bank inaction as deflationary forces multiplied and spread.  The solution for Bernanke is therefore a world where interest rates can be held below the inflation rate, and inflation generated by currency compromise at a time when prices might be expected to behave in a deflationary fashion.  Britain's secondary banking crisis showed the efficacy of negative real interest rates.  For Bernanke therefore, Britain's stagflation in the 1970s is a solution.  Alas, the bogey-man for the Bank of England is the self-same circumstance - a world where the English remember the wholesale incompetence of economists and bankers alike (Messrs Gordon Richardson and Jasper Hollom's lifeboat a shining exception to this).  The present team will do anything in their power to prevent its recurrence.  When Sir Mervyn King and his deputy governors talk of fighting inflation, alas, they mean it.  The ECB plays the same inflation-busting tune, but less culpably: they do it to establish their credentials as warriors of free thought, and, as for a regiment, battle honours are more important than the outcome of the battle itself.

International money flows are no longer favourable to a unilateral attempt by Bernanke to bring about this necessary result.  In the good times, the oversupply of dollars which resulted from the Fed's loose policy was reinvested in the US fixed-interest market.  Now the emerging markets, who are the recipients of excess dollars, prefer to recycle those dollars into 'real' assets like oil and wheat.  Rising prices of such staples quickly change domestic inflation expectations in America, and compromise bond market yields.  This worsens the squeeze in credit markets.  This has meant that Bernanke has had to pause in his fight to use loose money to keep the economy in order.  The rhetoric has increased: a table-thumping diatribe for sound money, although nothing has been done to restrain money growth or put up interest rates.  Nevertheless, it has ensured that in the last few critical weeks, the economy has had no help and this has translated into extremely messy markets as the economy weakens sharply.  This is the background to the world that we see going forward.  In the short term, these developments are not supportive of our new-found enthusiasm for index-linked stocks as a weak economy suggests a strengthening of the deflationary conditions.  Without evidence that the authorities will respond inflationarily, the deflationists could well come centre-stage.  If this turns out to be the case, our philosophy of never having all our eggs in one basket will prove vital.  If, in the early autumn, the world looks to be succumbing to deflation, then we would expect all three central banks to respond vigorously with expansive policies, and our primary view will swing back again.

It is a pleasure to be able to report that there is beginning to be some value in the equity markets.  The opportunities are few and diverse - the old adage about glisters and gold remains true.  Integrated oils, some telecom stocks, Japanese domestics, some food manufacturers and a range of debt-restructuring opportunities all look like they could provide good returns from here.  We find nothing in the banks or the house builders: not much, either, in the retailers (except in Japan, and possibly the food retailers).  We remain of the view that a deflationary scare will provide a last - and possibly the best - opportunity to put in place a full protection against tomorrow's challenge: inflation.

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Investment Review April 2008