Inflation wrestles economic control from central banks

Move over Greece – oil is rapidly becoming the new risk item for investors. Unlike some commentators, we believe a rising oil price will inevitably have a deflationary effect, as opposed to inflationary. Both scenarios are something investors should be poised for, over different time periods, as volatility in the oil price is a near certainty this year.

Generally speaking, when a trend is established in the commodity markets, it can take very little for momentum to take hold. Furthermore, macro research suggests that a strong relationship now exists between inflation pressures and economic growth, due to zero interest rate policies in the West.

In short, it suggests that lower inflation now acts like monetary policy. In other words, while central banks have in the past looked to guide the economy methodically using interest rates as a lever, inflation is now taking over.

It points to the increased importance of inflation in economic and business cycles, but it also highlights that changes in inflation trends, owing to machinations in the commodities markets, are far less predictable too. This probably means that cycles will be shorter over the next decade. We would never call the oil price, but there is a cocktail of events right now that points to it rising in the short-term.

In brief, tensions in Iran are ramping up the oil price, as are supply disruptions in other troubled regions such as Syria and Libya. Ageing oil fields are also tightening supply as is a pick-up in demand, emanating from the emerging markets and Asia; healthy lead economic indicators also suggest demand is likely to continue.

Add to this a dose of speculation and oil looks to be heading towards a peak (in the US, gasoline prices are already edging toward the psychologically significant $4 per gallon). Furthermore, an important disconnect is also becoming apparent: while demand from the developing world is growing, consumption in the developed markets is slowing, just as prices are rising. The big risk is that higher prices derail a recovery in the US and strangle any nascent shoots in Europe. Are we right to be worried?

In the short-term, yes we are, as oil will be subject to cost-push inflation. We are hedged for this scenario in our growth strategies through the Investec Global Energy fund, which remains heavily invested in integrated oil and gas, E&P and some oil services stocks.

The fund is a good Beta play on the sector and its large cap exposure means it is less volatile than smaller cap funds. We also have a position in Norwegian kroner sovereign bonds, in our total return strategy.

In the medium- to long-term, however, a higher oil price will act as a tax on growth, and we estimate a tipping point of around $150 per barrel. This is when discretionary consumption falls, as energy demand is relatively inelastic. The best hedge for this would be long-dated conventional government bonds. Anyone brave enough?

David Coombs is head of multi-asset portfolios at Rathbones. The views expressed here are his own.