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Markets hit the ground running in 2011 as the issue of inflation starts to rear its head.

We have had a fast paced start to 2011. As we near the end of the first month of the year, the markets have been active and already there are some clear economic themes beginning to emerge.

Using the FTSE-100 as a proxy for market performance so far this year, the Index looked as though it was steady above the 6,000 points threshold that it broke through at the end of 2010. A combination of early mergers and acquisition speculation, strong data from the US on jobs and manufacturing and a positive reaction to Eurozone bond issues, saw the FTSE-100 above the 6,000 mark everyday apart from three in the run up to 18 January. Its peak of 6,056 on 18 January was a two and a half year high.
 
However, weak earnings results from the US and poor UK unemployment data were then followed by strong Chinese growth numbers. This had a direct knock-on effect on the FTSE 100. The index lost a lot of ground, shedding over 180 points across 19 and 20 January. Despite a mild recovery, the index is now still languishing below 6,000.

After over two years of fiscal prudence from the UK government, with interest rates at historic lows, the inevitable threat of inflation is coming to the fore. The strong Chinese growth data was the real catalyst for the market pulling back; inflation fears arose as a direct consequence.

What is inflation?

Inflation n 1 a general rise in the prices of goods and services in an economy, which consequently leads to a reduction in the real value of money or the underlying spending power.

Inflation generally stems from economic growth so policy makers and governments must constantly try to achieve a balance between stimulating that growth but at the same time, keeping inflation in check. It can be a very fine balancing act.

Since the credit crisis in 2008 and the subsequent global recession, the key focus has been to reverse this trend and move the global economy back towards steady growth. Two key measures generally applied were the reduction in interest rates and the injection of capital into the economy. 

However, now those measures have, in most cases, successfully triggered growth, that growth has to be managed well. If inflation is left to escalate and develops into hyperinflation, then an economy can become “over-cooked” and the underlying value of money within that economy dwindles rapidly.

China and inflation

The release of positive Chinese growth data shows that the Chinese economy continues to strengthen, but it also heightens the risk of inflation. Although the Chinese Central Bank has already raised interest rates, on Christmas Day, the country may look to implement further inflation prevention.

How do we beat inflation?

The general concern amongst global markets is the fight to control inflation. Now that inflation fears are firmly on the Chinese economic agenda, they will begin to cascade through to everyone else. It seems inevitable that tackling inflation will be a key economic focus in 2011, the main question will be when and how policy makers go about it.

From a UK perspective, the unexpected news on Tuesday 25 January that the economy had shrunk by 0.5% as a result of the cold weather in late 2010, raised speculation that concerns about faltering growth might stem the onset of higher inflation, at least for a short period. However, subsequent comments on Wednesday 26 January from Mervyn King, the Governor of the Bank of England, asserted the view that inflation will continue to rise, with King forecasting a move to between four and five per cent in the coming months. King stated that the current rate of inflation, which stands at 3.7%, well above the bank’s target of 2%, has been driven by higher import prices due to sterling weakness, rising energy and commodity prices and the recent increase in VAT.

Investors concerned about the impact that inflation may have on their portfolios may wish to consider investment products that factor inflation into their performance.  For example the iShares Barclays Capital Global Inflation-Linked Bond (SGIL) is an Exchange Traded Fund (ETF) that that aims to track the performance of the Barclays Capital World Government Inflation-Linked Bond Index. The Index itself offers exposure to developed world government inflation-linked bonds issued in the domestic currency of each country.

You should bear in mind that the value of investments such as ETFs, which track inflation-linked bond indices, can go down as well as up and you may receive back less than you invest. You should ensure that you read and understand the full simplified prospectus for such products.