King Canute and the China Moon

With rising energy and food prices continuing to concern consumers and central bankers, the spectre of inflation is threatening the bond markets. There seems no respite from these inflationary forces. Ordinarily this would appear to be a very bad environment for government bonds, but there are some key reasons why the traditional response could be different this time.

In this environment of higher prices one would expect higher wages, but in the developed world this has yet to happen. Given tighter credit, falling house prices and the threat of unemployment one has to ask who is going to pay for these elevated costs? For example, within the airline industry fuel prices can be 30% of costs which is higher than airlines' labour costs (according to British Airways). In response, pressure to keep staff costs low remains, resulting in capacity cuts. A $1 increase in the oil price per barrel wipes £16m from BA's profits. This shift in the oil price since the end of March has written £526 million from their bottom line, assuming no fuel hedges and no benefits from fuel surcharges. American Airlines' chief executive put it this way: 'the airline industry, as it is constituted today, was not built to withstand oil prices at $125 a barrel'.

A high cost of living, together with a decline in wealth and no corresponding increase in wage growth, make a recipe for government intervention. This could take many forms, but the sight of a homeowner who can't afford his mortgage, his SUV, or get a loan to buy that new boat is too much for the average politician to bear. The US housing slowdown has been going on for long enough for the legislative process to get its act together and set up a proper government bailout, but the election may get in the way in the short-term. With house prices so depressed, any short term cost to the taxpayer is likely to be recovered over time. This happened with the Home Owners Loan Corporation which was established during the Great Depression and was wound down in 1951 with a small profit.

Meanwhile, attention is also focussed on those nasty investment bankers who, we are told, got us into this mess in the first place. If the Federal Reserve has to support them as well, then the investment banks should face additional regulation to bring them into line. The latest piece of control being talked about is focussed on those commodity speculators who have jumped on the 'China demand bandwagon' supposedly causing another bubble. It will be hard to legislate for such speculation but don't underestimate the demand for the government to act where food and shelter are concerned. Speculation that affects investments is one thing, but when it kicks you out of your home and means you can't eat, suddenly politicians get very interested. Meanwhile the central bankers are responding in different ways. The Federal Reserve, with its mixed remit of growth and inflation fighting, has slashed interest rates. In Europe both the Bank of England and the European Central Bank are mandated to fight the headline inflation risk which is, in fact, outside their jurisdiction. They seem akin therefore to King Canute in the face of the rising inflation tide whilst China is the Moon.

The response from the emerging market regions is the most worrying in the long term for the markets overall. Without a deflating housing market, and with fuel and energy being higher components of spending, the response from the authorities is different. Subsidies are being applied and export restrictions put in place. However, with headline inflation rising rapidly, for some, the response has been to raise interest rates and put in place other measures to reduce domestic demand. The last time inflation spiked in China in the 1990s, the authorities successfully choked demand and were able to reduce inflation

Bond allocation, within the global dynamic bond strategy, has a mixture of US and European government bonds (with some inflation-linked bonds) and investment grade corporates. The government bond markets should remain attractive whilst the consumer remains depressed and they may provide an offset to higher equity volatility during the summer. Within the investment grade area there is a bias towards financials which are busy re-capitalising. High-yield bonds remain vulnerable to rising default rates and are an underweight for now. However, emerging market sovereign bonds are slightly overvalued at the moment and the local markets are vulnerable to rising short rates.

Within emerging market currencies one has to be selective with those that 'have' and those that 'have not'. Generally, if they have a current account surplus then they can continue to do well. Raising interest rates to slow domestic demand when you have a high current account works, but it doesn't work if you need growth to attract outside capital.

One of the best ways to work through this minefield is to use long term themes. We recently completed an exercise in classifying these bond holdings by theme within the global dynamic bond strategy. The following list shows the sum of bond holdings by theme. Many holdings are influenced by more than one theme so the percentages add up to more than 100.

The currency allocation can also be analysed along theme lines as follows 1 :

Europe's inflation-fighting central bankers may get swallowed up by the tide, but for bond investors 'wage inflation' and 'core rates' are the statistics to watch out for.