Facing both ways on the inflation outlook

One reason for such activity is that nobody knows which way to jump vis-à-vis inflation. This makes a very big difference to investment strategy.

On the one hand, you may believe inflation is about to take-off. Look at recent consumer price data, which is up a little, worry about the impact of rising oil and other commodity prices. It is not hard to make a case for a more inflationary investment environment.

Then you should be investing in real estate and resources stocks and getting rid of fixed-income instruments. Indeed, many investors are positioned in this way, or at least enough of them to sustain property and equity prices and leave bonds depressed.

On the other hand, Asian economies continue to export deflation in the form of ever lower prices for consumer electronics, clothes and manufactured items; and there is no doubt that the flow of manufacturing investment continues to go into China, for example.

Also while short-term US interest rates rose by 25 basis points last month, at the same time the cost of long-term money fell by 130 basis points. What does this tell us? It says capital markets are pricing in deflation and not inflation.

Why should this happen? Well, the US economic recovery has only just started after a three-year slowdown, unemployment is high, and personal, corporate and government debt is at a record high. Stocks are overvalued and it is not difficult to see higher short-term interest rates due to high oil prices causing a stock market crash. October is the traditional month.

Under such a scenario short and long-term interest rates would be quickly reduced again. But the knock-on effect would most likely be a depression of other asset classes as well, such as real estate, leading to deflationary pressures across the board like we saw in Japan in the 1990s.

No wonder the investment professionals are in a state of denial watching cricket and tennis in London. The stock market patterns of the late 1990s and early 2000s exactly mirror the late 1920 and early 1930s, and it may be that the final leg of this bear market is just as brutal.

Or it maybe that Mr. Greenspan's sophistry manages to bumble past the danger zone and into another dynamic phase of expansion. The trouble with that argument is that markets just don't behave like that, and a final sell-off before the new dawn is the classic pattern, not General Custer arriving with the Seventh Cavalry.

In the deflation scenario bonds are a good buy, and equities and property a disaster. Inflation or deflation? It really matters.