Inflation outlook still benign

Despite clear evidence of a pick-up in global growth, some fund managers believe this will not be inflationary and, as a result, are positive on the prospects for bonds.

Ian Harwood, strategist at Dresdner Kleinwort Benson, says: "Global growth is picking up strongly and the composite lead indicators we follow suggest that this process has further to run. Unsurprisingly, given the inflationary experience of the 1970s and 1980s, bond investors worry whether current low inflation will last.

"Commodity prices, especially oil prices, have jumped sharply while output gaps are beginning to narrow world-wide. We believe, nonetheless, that such inflation angst will not prove justified, just as it was not back in 1994."

Dresdner is fundamentally bullish on bonds, Harwood says.

"Not only will core inflation remain low but short-term rates are unlikely to rise as much as is currently implied by the futures contracts. The resumption of the long bull market in bonds is surely a matter of timing."

There are nevertheless two potential impediments to 'value' at the long end of the curve being fully released.

"The US current account deficit is becoming increasingly difficult to finance because Asian surplus savings are being drained away as their own burgeoning current account surpluses decline. The US is having to fight to get its hands on increasingly scarce global capital. There is a flow of funds problem. Real yields are rising.

"We are also concerned that the markets could be disturbed by a snapback in US wage inflation. We view the recent deceleration as temporary. The restraining impact of last year's lower CPI inflation and the profits recession have reversed."

Peter Price, head of fixed interest at Hill Samuel Asset Management, also believes equities are at risk of a period of underperformance relative to bonds.

He remarks: "Global economic growth should continue to surprise on the strong side. Robust US domestic demand has been the key driver but Asia and Europe are now taking up the mantle.

"However, we believe inflation will remain stable. Broad commodity indices and wage inflation are relatively stable. Global excess capacity and technological developments such as the internet will maintain downward pressure on prices.

"This benign inflation outlook will ensure that any interest rate rises will be very modest. As a result, we have moved overweight in bonds relative to cash in our global portfolio, and remain neutral in equities. Bond markets have retreated to attractive levels. Yields should fall over the next 12 months."

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