LOM Weekly Perspectives

Things are panning out as expected -- as far U.S. economic growth prospects are concerned. At the same time, there are legitimate, creeping, worries that there will be upside surprises regarding inflation, later in the year. As we pointed out last week, barring a sharp and sustained increase in energy prices, there is little likelihood of a surge in inflationary pressures. We noted that the policy framework has not deteriorated inordinately, to make a spiral possible. Nevertheless, the risk of an uptick in inflation, before the year is out, has indeed increased. There are a number of factors involved: (a) the current easy stance of the Fed, (b) the rise in commodity and energy prices, (c) the possibility that productivity growth may be weaker than expected, (d) the need for corporations to raise prices to help the bottom line, and (e) a possible slip in the value of the dollar. Counteracting forces are in the form of excess capacity and intense price competition.

Naturally, fixed income investors and those with a long horizon, such as pension fund managers, are already sensitive to the danger signs -- ready to adjust the duration of their portfolios and look for inflation protection. As a measure of expected inflation, the spread between TIPS (Treasury Inflation-Protected Securities), which are indexed to inflation, and non-indexed Treasuries has widened. The Fed may continue with a relatively easy monetary policy, but in terms of policy effectiveness, it has limited power at the longer end of the yield curve. Its clout is mainly on shorter-maturity instruments. So longer-dated notes and bonds can quickly fall in price in proportion to anxiety about higher expected inflation. Of course, policymakers may engage in plenty of propaganda to moderate increases in long-term interest rates.

In this context, fixed income investors may wish to re-examine the vulnerability of their portfolios to a rise in inflation risk, unless they think that real growth will be considerably lower than current consensus expectations. Meanwhile, a little bit of inflation is good for stocks, as long as growth is fairly decent. A less pleasant outcome would be one of slow growth and high inflation. This sort of scenario is commonly referred to as stagflation. The rise in oil prices has set off reminiscences in the media about the experience of the 1970's, implying that we may get a repetition. However, this is a low-probability outcome because the demand/supply situation, the policy framework and the structure of economic activity are very different now, compared with the earlier period.

Some of the big blue-chips have come up with less-than-convincing earnings reports and this has troubled the markets somewhat. But, on the whole, investor commitment to the stock market has refused to wane. Given the whacking that the market has taken from a variety of sources over the past two years, this is pretty remarkable. Evidently, the equity culture is still very much alive. People are willing to step up to the plate and have another go. The previous bubble trouble is almost forgotten and investors are impatient for a return to the good times and don’t want to miss out on potential rallies. This represents a signal difference with bubble busts in the past. Mind you, in many cases the amount of smashed-up crockery, after the party was over, was so great that it took a long time to clear up. But in this case the Fed stepped in good and early to limit post-party blues. In previous bubbles there were fewer safety nets erected by kindly central bankers to save the neck of those doing high-trapeze acts, as well as run-of-the-mill circus participants.

It is still very difficult to get many badly-burned Japanese investors to re-enter the equity market, years after the Nikkei crash. But then again, the United States has always been a society where risk appetite was greater than elsewhere. In many cultures making a loss on an investment or a business venture is counted as a failure. In the U.S. it is more likely to be regarded as a lesson learnt and an impetus to try harder. For many investors their risk tolerance is assessed in terms of losses relative to some reference point rather than a quantitative calculation of prospective risks. The reference point for many may not be Nasdaq at 5000 but Nasdaq at 1000 -- and they are still well ahead of the latter. Also, a brief examination of the long-run historical performance of stocks relative to other instruments is impressive, at first sight. The trend looks good. Never mind that it has to be interpreted carefully. We should also mention that individual investors need good returns from the stock market, for years to come, in order to fund a comfortable retirement. High returns would allow them to do this without having to forgo current spending and increase saving rates.

Wall Street types are of course decidedly in favour of a revived stock market and are very good at selling Monty-Python-type dead parrots. And we must not forget esteemed corporate managers who have a substantial portion of their compensation tied to stock options, which requires the company's stock to rise in value. After the bursting of the tech bubble many stock options were seriously out of the money and were re-priced to make them more attractive. In the current environment, where the rationale for the granting of stock options and its accounting treatment is being questioned, re-pricing may become more difficult to justify. This increases the managers’ motivation to boost the company’s share price.