8 August 2008: Barclays Wealth research says inflation containable, equities should benefit

The August edition of the Barclays Wealth Signpost monthly update, Caging the beast, argues that inflation is unlikely to cause major problems, in the developed economies at least. With risk appetite returning, and the possibility of a further fall in oil prices, we should be guardedly optimistic about the future.

Michael Dicks, Head of Research and Investment Strategy, Barclays Wealth, said: "Fears regarding the beast of higher inflation are likely overblown: we can get him back in his cage. As the US housing market adjustment shows, time is a natural healer, and inflation pressures will peak before year-end.  So long as there is not another surge in oil prices, this should entail some further recovery in stock prices. Thus we continue to recommend a small overweight of equities versus bonds, with the United States still looking to us like one natural place to be overweight."

The economic outlook in brief

The market slide in early July was less severe than that surrounding the collapse of Bear Stearns in April which, in turn, was less acute than the downturn at the start of this year. By the end of July, risk appetite indices had returned to close to their long-term average, although they remained far below their pre-crunch levels in early 2007.

The market recovery in the second half of July also took place despite continued poor economic macro-economic news.  As a result, forecasters have been revising their growth expectations down for the developed economies. We too remain generally gloomy about growth in 2008, although we think that US policymakers’ efforts will have a beneficial impact on the US economy. We have revised upwards our 2008 US GDP growth forecast to 1.3%, and expect a further slight pick up in US growth in 2009, although growth in the UK and Euro area will fall.

Consensus inflation forecasts have also been rising, but we remain confident that we will not experience a proper ‘inflation’ – in the sense of sustained wage price spirals in the developed world.  Wage inflation has generally remained quiescent and core inflation (excluding food and energy prices) remains low, suggesting that underlying price pressures are muted in the US, Euro area, UK and Japan. 

However we are concerned about the outlook for inflation in the developing world, where wage/price spirals are already gathering force. Developing country central banks are already tightening policy, but have a long way to go. Real interest rates are often negative, but interest rate hikes will be unpopular, and changes to developing countries’ currency regimes could prove uncomfortable.

Oil prices will be key to future developments. Agricultural prices have already fallen back, reflecting increased supply, and oil could do likewise, helping to contain inflation. We have refined our model for forecasting oil prices, looking beyond immediate supply/demand issues to include factors such as refinery utilisation rates, non-linear OPEC capacity changes and conditions in the futures markets. The model suggests a ‘fair value’ for oil of around $80/bbl – some way below current levels.

The likelihood that inflation pressures will peak before year-end, in the absence of another surge in oil prices, should result in a further recovery in stock prices. Thus, we continue to recommend a four percentage point overweight of equities versus bonds, with the United States still looking to us like a natural place to be overweight. We suggest funding the equities overweight through being underweight in government bonds and cash.

We suggest, however, that investors take out some insurance against another run-up in commodity prices – even though we think that a further increase in prices would not be justified by fundamentals. For those investors who use our Investment Philosophy to guide them, a natural way to do that would be to place an overweight on commodities in the ‘guided portfolio’ component. For those who, instead, use a benchmark which comprises inter alia a commodities component, a small tactical overweight looks to be in order.

Copies of the report are available on request, or you can download the PDF: 
Signpost Monthly Update August 2008: Caging the beast [1.40 MB]

You will need Adobe Reader or similar installed on your computer to view the file.

For further information contact:

Barclays Wealth
Nicola Hankey, Head of PR
020 7114 9813 / 07775 548418
nicola.hankey@barclayswealth.com

Jignasa Patel, PR Manager
020 7114 9813
jignasa.patel@barclayswealth.com