Inflation, US dollar weakness, equities, gold and property

You can be quite certain that by the time most people have noticed an economic trend, such as low inflation, its time may already have past.

There are many indications that inflation is about to trend higher. Commodity prices from gasoline to steel have moved seriously higher in the past year or so. Now we know that there is a time lag between higher raw material costs and higher prices to the consumer.

Thus as 2004 progresses there will be more and more signs of consumer price inflation. It is already about 3% in China, the country that once exported low inflation to the world, and rising.

There is also a growing consensus of opinion that the Fed has left US interest rates too low for too long, fuelling up an asset price bubble in housing, and keeping consumer demand above where it should be at this stage of the business cycle. Any junior student of economics knows that when demand is above supply, prices rise.

Once the inflation genie is out of the bottle, it is very hard to get it back in again. A nasty combination of higher interest rates and higher taxes to depress consumer activity is perhaps the only solution, but this takes time and for those with high levels of debt this experience can prove fatal.

For stock markets higher inflation is bad news if it brings higher interest rates. The price of shares is determined partly by dividend yield, and when interest rates rise share prices have to fall to increase dividends.

Now conversely the prospect of higher interest rates will strengthen a currency. Thus the US dollar would go up in value if interest rates went up; this would have the unfortunate effect of making US exports more expensive and so be bad for businesses already struggling with higher debt servicing costs.

I suppose where this leads us is to a rational assessment of the true position of the US business cycle, which is not one of solid recovery but of an imminent correction for past excesses. Inflation is one of the things that is about to trip up this false recovery.

What does this mean for investors? 'Sell, sell, sell, and go away!' That might be a fair answer, and if you are really gloomy go for gold which is a contra-cyclical asset class; is there anything to be cheerful about?

Well, if you do have large debts and can afford the higher interest rates, then inflation will gradually eroded the size of the debt relative to your income; debt is fixed and income is not. This is also especially true for property where rental income will rise with inflation while debt will fall as a proportion of the inflated value of the asset.

Thus well-financed property assets and gold may be the best places to hold your money as inflation heads upwards in 2004, but equities may face an uncertain time. Watch this space!