Global equities keeping inflation at bay: each month, What Investment speaks to fund managers and analysts, focusing on four different asset classes, and asks them to reveal the key issues currently driving their investment decisions

There have been numerous events over the past few weeks to unsettle the global equity markets, including the presidential election in France, the growing political impasse in Turkey and the determination of central banks to keep the lid on inflation by keeping interest rates higher than they have been or, like our own Bank of England Monetary Policy Committee (MPC), raising them still further.

Looking at the most recent UK base rate rise, although it was widely anticipated, this did not stop economists disagreeing over its likely effects. Edward Menashy, economist at stockbroker Charles Stanley, pointed out that 'Of the 61 economists polled by Reuters, the majority anticipate a further 25 bps increase in August 2007. By way of contrast, I believe that 5.5 per cent is likely to prove the peak of the current interest rate cycle, for four reasons: according to the Bank's governor, CPI inflation is set to decline rapidly; consumer expenditure, which accounts for 75 per cent of GDP, is weak under the weight of stealth taxes; the provision of mortgage finance has decelerated; and wayward money supply is no longer a predictive forecasting tool.'

John Greenwood, chief economist at AMVESCAP, pointed out that 'The statement from the MPC accompanying the rate hike highlighted the fact that business investment had been stronger than expected and the pace of expansion of the international economy remains robust. Inflation risks were said to be "tilted to the upside" in the medium term. Lower gas and electricity prices and weaker import price inflation mean that "CPI inflation is likely to fall back to around the two per cent target in the course of this year".'

He added, 'Although the rate hike was widely expected and fully discounted, it cannot be assumed that inflation will diminish quickly or easily. Above-target inflation is becoming more entrenched. Even with sterling being strong, goods prices rose to 2.5 per cent in March, in contrast with absolute declines experienced during the years 2000-05, while core CPI, which excludes energy and seasonal food prices, rose 2.3 per cent. More fundamentally, double-digit money and credit growth need to be slowed to single-digit growth rates in order to be sure of returning to the two per cent CPI target.'

Simon Ward, chief economist at New Star Asset Management, urges that 'The MPC should resist calls for early further action. Monetary conditions have tightened significantly over the last year and New Star's leading indicator is signalling a slowdown in the economy in late 2007 and 2008. A bank rate of 5.5 per cent is modest by historical standards, but represents a heavy burden on consumers carrying record debt. Interest payments will soon absorb nearly ten per cent of households' income, a higher proportion than in 1998, when official rates reached 7.5 per cent.'

Certainly, the UK stock market seemed unperturbed by the latest rise, with the FTSE 100 Index, sailing through the 6,600 level the day after the MPC announcement, 'continuing a strong rise that began last June', according to Simon King, a senior investment manager on Gartmore's UK equities team. But he added, 'The way up has not always been easy. Over the past year, investors have had to contend with a continuing war in the Gulf, terrorist threats, avian flu, rising inflationary pressures, higher interest rates and a strong pound. Strong corporate cash flows, robust profits growth, a growing world economy, M&A activity and the fact that equities do not look expensive compared with bonds justify the rise, and we remain positive about the outlook for global demand.'

Turning to the outcome of the French presidential election, his colleague, Guillaume Rambourg, co-manager of the Gartmore European Selected Opportunities Fund, observes that 'Sarkozy's campaign, which focused on labour and fiscal reform, and on "putting France back to work", was the more appealing to the market, when compared to Segolene Royal's less ambitions status quo programme. It now remains to be seen whether Sarkozy will have both the energy and the will to push through the major reforms that he has pledged.

'Many have made similar promises before but have balked when confronted by opposition in the streets. With a Sarkozy victory already factored into our stock selection process and no major movements in European markets since the election, the impact on our portfolios has been minimal.'

Taking a more global view, Terence Mahony, research director at multi-manager specialist IMS, feels that 'The world's equity markets recovered much more quickly from the February/March five-week sell off than they did from last year's May/June correction, which lasted four to five months. The main explanation is that in a slower global economy there is less concern about inflation. Also, the world is generating excess liquidity through a fundamental mismatch between savings and investment. Consequently, there are not enough financial assets for investors to buy and hence the attractions of the "Brave New World's" riskier assets. Nevertheless, in such a heady environment, one must remain sanguine.'