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Inflation risk to fade in 2006 says MLIM

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Reduced inflationary pressures, maturing commodities markets and a strengthening Japan will be the key investment themes for 2006.

That’s the view of Merrill Lynch

Reduced inflationary pressures, maturing commodities markets and a strengthening Japan will be the key investment themes for 2006.

That’s the view of Merrill Lynch Investment Managers, whose Head of Global Research & Investment Strategy, Ewen Cameron Watt, also believes that gloom on the UK high street has been overdone and there is good value in financials.

“Our key message for 2006 is that we believe inflation risk will fade and US dollar interest rates will peak in the first half.” says Cameron Watt. “After a strong 2005 for commodities, driven by on-going demand in China and India, 2006 will see a maturing commodities market, with slow price appreciation easing.  We see a positive outlook for Japanese equities in 2006, as the country continues its return to more steady and sustainable growth levels last seen in the 1980s. Finally in the UK, we believe the gloom on the high street has been overdone and financials in particular offer good value.

“This time last year, we predicted the US dollar rate would strongly influence the outcome of other global investment trends. We advised investors to remain exposed to the oil, energy and commodities sectors and that the gradual rise in interest rates in most of the developed markets meant investors should be weighted towards short dated bonds and high yield corporate debt. While these predictions all proved correct, we also said that following two years of accelerated earnings growth, 2005 was likely to see global earnings slow. In fact, 2005 proved to be another year of robust earnings growth, continuing the trend seen the previous year.”

Key Investment Themes for 2006

Theme 1: Commodity bull market matures as China slows: 2004 saw a string of record results from major mining and energy companies, driven primarily by the industrialisation of China. Company results for 2005 proved even better and while demand for commodities remains strong and prices are likely to remain high, the commodity market will mature as demand from China slows. MLIM is more positive on the outlook for energy.
Theme 2: Falling inflation sustains liquidity: the on-going growth in oil and commodities prices has fuelled fears of inflation. However, core inflation in the US is under control, while inflationary pressure continues to ease in many of the world’s emerging markets. The outcome will be that inflationary pressure will not put a strain on the availability of money.

Theme 3: US interest rates peak, Euro rates rise: the US Federal Reserve has initiated its tightening cycle, signifying an end to inflationary pressure, while in Europe a tightening policy from the European Central Bank is only just beginning. We believe the trend seen in 2005 will be reversed in 2006, with US rates peaking while in Europe we will start to see a tightening of fiscal policy.

Theme 4: Yield curve to steepen: a rising yield curve will positively impact financial stocks, which will benefit from increasingly favourable lending rates.

Theme 5: Fiscal concerns return to bond markets: Anglo-Saxon countries’ bonds are likely to be expensive in 2006: the US, UK and Europe have all seen budget deficits rising over the last five years, increasing the risk for bonds in 2006. Beyond 2006 we may also see a two-tiered bond market develop in Europe, where countries such as Greece, Italy and Portugal are running high budget deficits while others such as the Netherlands and Finland have stronger financials.

Theme 6: Emerging markets risk is declining: valuations in Latin America are below historic levels, offering investors growth opportunities. The weak dollar combined with high commodity prices still bodes well for most economies in the region, while robust economic management is helping to bring inflation under control. Elsewhere, economic liberalisation, convergence with Western Europe and high energy and commodity prices, have created strong opportunities for investors in emerging Europe.

Theme 7: Japan: back to the 80s? Japan has experienced another year of domestic growth, a sign that it has emerged from the rocky 1990s. The current strong performance has been based on overseas investors buying Japanese equities. Domestic investors are still net sellers, so there remain incremental buyers ready to re-enter the market encouraged by rising real estate values.

Theme 8: The earnings cycle is maturing: earnings in 2005 were boosted by energy and commodities and are now historically very high. As these sectors mature, we are unlikely to see continued high earnings growth, particularly in the US. As a result, we believe we will see investors moving away from cyclical stocks.

Theme 9: Equities – Look for valuation support. In an environment where earnings have been above trend, the UK market has lagged and still looks good value, in particular in the financials sector. Europe is also trading on a similar price earnings ratio to US, showing that the US is not trading at its historic premium. As a result, MLIM prefers the US over Europe for 2006.

Theme 10: UK consumer – outlook too gloomy? There remains a sense of gloom on the UK high street. Retailers claim conditions are tough, exacerbated by downward pressure on house prices in 2005. This is priced into the UK market. The sense of gloom is overdone.  An environment of stable interest rates in the UK will ease mortgage interest repayments. A recovering high street in 2006 should have a positive impact on UK stocks in 2006.


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