Hamish McRae: Investors worried about the risk of inflation take a shine to gold

Economic Life
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So the International Monetary Fund now expects things to be rather better than previously forecast. About time too. One of the dispiriting features of the past year has been the way in which official forecasters, including the IMF, were firstly far too optimistic about the scale of the recession, then when things became really dire, hit the panic button and arguably depressed sentiment even further. The IMF is not alone in this over-compensation. The OECD forecasts for the UK are currently too low and will, I am sure, eventually be revised up. But this experience should warn us all about the limits of economic forecasting.

Or, if you are an investor, the uses of economic forecasting. It gives you something to bet against. As we can now see, back in the spring, when the forecasters were at their most catastrophic, it was a wonderful time to buy risky assets, the riskier the better. Take equities: the second quarter was the best on record for the UK since 1975 and shares globally have just completed another record three months. You can make the point that it is easy to have a great leap forward if you start from far enough back, and the markets in the developed world are still a long way from their peak. But now that the markets have recovered their nerve, you might reasonably ponder quite how much good news is priced into them.

There will be a recovery, but it may be 2013 or 2014 before all the ground that has been is regained: ie, before total output is back to the peak it reached around March last year. The forecasters agree that there will be some growth next year, but probably below the long-term trend. I have not seen any UK forecast that suggests growth next year will be above 2 per cent, not even the Treasury's, yet the long-term trend is about 2.5 per cent.

Now it is quite true that the FTSE 100 index is not an index ultimately determined by UK economic activity. Something like two-thirds of the profits of its members come from abroad, either in terms of overseas subsidiaries or profits on exports. So you could justify UK share prices running ahead of the British economy if the world economy as a whole does so. But there is a widespread feeling within the investment _community that after this astounding bounce, the performance of mainstream assets will be more muted in the months ahead. So what do you do?

I have been looking at recent work by two houses that have had a good record on catching the upswing: Barclays Wealth and Goldman Sachs. Barclays' new investment strategy note makes the point that not only are the estimates for growth for next year being revised upward, but the risks that are attached to these forecasts are being downplayed. Within Europe it favours companies in economies that do not have severe fiscal problems, such as Germany, rather than the UK, which clearly does. (Germany will be cutting taxes next year; we will be raising ours.) It also favours smaller companies, and in particular it thinks investors should seek opportunities in Asia, to take advantage of the region's growth prospects.

This last point is particularly interesting. From an economic perspective, one of the really fascinating aspects of this cycle has been the extent to which the downturn has speeded up the long-term shift of economic power to Asia. This is continuing. Just yesterday we had rather dismal figures on US manufacturing expectations, and pretty upbeat ones from Asian purchasing managers. And you can see it in the numbers for industrial production. There has been a V-shaped rebound in the emerging markets, reflecting the Asian performance, while the bounce in the developed world has yet to materialise.

The markets have recognised this. We have had a share rebound here to be sure, but look at the way Asian markets have shot ahead. The very fact that they have risen so much already might make them vulnerable in the months ahead, but Barclays suggests there are ways of benefiting by buying into markets that have been left behind, including Japan's.

That leads to a further theme, developed by Goldman Sachs. It is that just as the series of shocks that have hit the world economy have affected different parts of it in different ways, so the recovery will be differentiated too. As far as the developed world is concerned, it did not matter whether a country had a solid financial position or whether it had experienced a housing bubble. Everyone went down pretty much in line. But now the recovery is happening, some countries have more rebalancing of their economies to do than others. Thus those that experienced the biggest housing bubbles, such as the US, Ireland, Spain and parts of Eastern Europe, will face a longer adjustment. Those that have banking problems, including the US, UK, and much of the eurozone, will face bigger difficulties than those that have largely escaped, including Canada and Australia. Countries that depend on slower-growing developed markets to take their exports will find it harder than those that are exporting to the developing world.

This all makes a lot of sense. But there is something more: the I-word – inflation. There is a marked distinction now between financial professionals and high-net-worth individual investors, as a City economist told me the other day. When he talked to their money managers he found there was no concern about inflation. That was miles away, as indeed was the prospect of rising interest rates. When he talked to individual investors, the main thing they were worried about was inflation. The huge deficits incurred by governments gave them an incentive to try to inflate away their real value, while the various unconventional measures central banks were using to boost liquidity would ultimately feed through into price rises.

I have caught the same fears when talking with investors, and you can see it reflected in the gold price, which in real terms is moving towards the levels of the late 1970s, when inflation reached double digits.

To look at British circumstances, you might say that the Bank of England's quantitative easing programme has worked because it has held down gilt yields, made possible a boom in corporate bond issues, helped to restore confidence in other assets and eventually is making possible an increase in real output. But you could also say that it has enabled the Government to follow an irresponsible borrowing policy – double the level of the 1970s – without having to face up to the disastrous consequences in terms of the higher interest rates it ought to be paying on its debt. It may turn out that the Bank has been complicit with a plan that defrauds savers of their money. It is not really polite to say that, but it is what I find investors are worrying about.

Exceptional times do call for exceptional measures, and all the history of banking demonstrates that at times of panic the central banks must flood the markets with liquidity. So in the short time it is fine. But it all depends on how quickly the central banks around the world return to a conventional way of managing liquidity. This is not just a British issue. There are certainly dangers of getting back to normal too quickly, for you don't want to hit a still-fragile recovery on the head. But equally there are also dangers in delay, as the gold market is shouting loud and clear.