Improved 2011 outlook, but inflation looms beyond

Investors are likely to see better returns in 2011 owing to an improved performance by developed economies, but inflation is likely to have a negative impact on investments over the long term, says LGIM

Road sign indicating inflation ahead

Developed economies’ desire to stave off the negative impact of inflation in the next 12 months means good news for investors in the short term but runs a longer-term risk, Legal and General Investment Management predicted.

The US Federal Reserve is unlikely to tighten fiscal policy next year, due to fears inflation could stifle growth, but in the long term “they are running an extremely irresponsible fiscal policy”, said economist Tim Drayson at LGIM.

“No other country would be allowed to run such huge fiscal deficits,” he said, claiming its position was unsustainable.

“At some point, bond markets are going to wake up,” he warned.

“There is a potentially catastrophic rise in government bond yields,” he said.

That will not occur in 2011, as inflation will remain low without rate hikes to allow for growth. In 2012 the Fed is likely to come under pressure to tighten its fiscal policy however.

Yet with unemployment at around 9%, it will be reluctant to do so, he added.

For investors, that means bond yields have better growth prospects in the short term, but the medium to long term outlook is bearish.

Volume problems are likely when the Fed slows down its purchasing of US Treasuries, while its eventual withdrawal of quantitative easing will cause it to sell back some bonds.

Corporate bonds show a good spread when measured against government bonds. Premiums should contract, but for absolute returns the outlook is “not great”, said Drayson.

Equities are likely to tell a different story in 2011. The outperformance of emerging markets stocks over 2010 will be replaced by a better performance by developed market equities in the next 12 months, he said.

Stronger sales growth in the US will pass through to profits, giving a bullish outlook for risk assets next year.

The only threat to that is if a QE bubble emerges, Drayson said.

Commodities could suffer from a bubble–if prices rise to a level out of line with global growth–while impending inflation also creates risk an emerging markets bubble will occur.

“If everyone’s talking about it [a bubble], it tends not to happen, but there is a risk,” said Drayson.

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