US inflation fears keep world markets on edge

The past week or so has witnessed increased volatility in stock markets throughout the world in response to fears that inflation may have begun to rise in the world's largest economy.

Consumer Price Inflation (CPI) figures for April in the US showed a sharp rise in the headline rate of inflation to 0.7 per cent and a rise in the core or underlying rate to 0.4 per cent.

This was the biggest one month gain in the inflation rate for four years and compared with expectations of a rise of just 0.2 per cent in the core rate. This is still a low rate of inflation but if it were annualised it would equate to a rate of 4.8 per cent.

Of course one month's figures do not provide enough evidence of a significant upturn in inflation and it is likely that coming months will show some decline towards the prior trend. Nevertheless, these inflation figures are being seen as a warning shot that a gentle uptrend in the US inflation rate may have already begun.

A feature of the April data was that price rises were evident across most sectors of the economy. Many economists are viewing this as a sign that the robust and long-running US economic expansion is finally beginning to create sustained upward pressure on the rate of inflation.

The US bond market has certainly begun to build in an inflation premium and the yield on the 30-year US long bond is now very close to 6 per cent compared with a yield of only 4.5 per cent at the height of the emerging market crisis of late last year.

In contrast, the Irish long bond is currently only yielding 4.8 per cent. This rise in long-term interest rates points to a growing belief that the US Federal Reserve may soon raise short-term interest rates to choke off any incipient inflation. If such a rise occurs it is likely to reverberate across the world's financial markets.

In the first instance it will probably reinforce the recent strong trend in the US dollar exchange rate, and the euro could well weaken further particularly if the ECB reduces European interest rates later this year.

Equity markets are also likely to react negatively to any signs of rising US interest rates, but the extent of any downturn can only be guessed at.

If the experience of the past few years is a guide, any downturn could well be shallow and short-lived. However, given the very high valuations of most equity markets and, in particular, those on Wall Street, the risk of a sharp market correction would seem to be quite high.

Whatever about the overall level of stock market indices, the recent shift in sentiment favouring companies which are exposed to the economic cycle is likely to be reinforced by these recent developments.

A gentle rise in interest rates and bond yields is entirely consistent with a cyclical economic expansion. Therefore the share prices of companies in sectors such as oil, building, papers and chemicals should do relatively well.

It is the companies in the more highly-rated growth sectors such as pharmaceuticals, telecoms and technology whose share prices are most at risk to rising bond yields and interest rates.

For investors the long-term arguments for investing in equities remain firmly in place. Historically low interest rates mean that investors have virtually nowhere to go except to invest in the equity market.

However, it may well pay to concentrate on the previously less favoured market sectors which offer lower valuations and the prospect of a cyclical recovery in profits.