Is Stagflation Back?

8/6/2019 Is Stagflation Back?

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Is Stagflation Back? Page 1

Back to the 70s: who says stagflation is back?Olivier M. LumenganesoEconomist & Global Strategist Africa Emerging Capital Asset AllocationMarch 2011

Highlights

"Middle Eastern crisis will lead to an 'energy shock' for the West, increasing stagflation, David Murrin, Chief Information Officer and Co-Founder Emergent Asset Management which oversees nearly USD 1 billion.

Oil could hit USD 220 a barrel if "Libya and Algeria were to halt oil production together," analysts at Nomurainvestment bank predicted.

High oil price is risk to economic recovery. Indeed, the current high price of oil threatens economic recovery. According tothe International Energy Agency (IEA), oil import costs for countries in the OECD had risen 30% in the past year.This is equal to a loss of income of 0.5% of OECD GDP, the agency added.

Not only risk is driving oil, oil is also driving everything else. There are also concerns about the rising costs of other commodities. The UN's Food and Agricultural Organization (FAO) said the high oil price had pushed theprice of food to a new record. Global food prices rose to a fresh high in December, according to its Food PriceIndex. The previous record reached in 2008 sparked riots in several countries. If prices remain high it will be justa matter of months before the world's poor are hit by another major food price crisis. High global food prices riskhunger for millions of people. Poor people in developing countries spend up to 80% of their income on food. Somore social crises, core of the social unrest in the MENA zone mainly, are to come.

How can we combine robust economic growth with tightglobal supplies of such critical commodities as energy,food? 30 years ago, in a austere part of the 1970s, an

economic phenomenon emerged that was as ugly as itsname: stagflation . Like the disco era it dominated,stagflation has a distinctive beat: slow growth, risinginflation, high oil prices and weak labor markets. In the1970s this nasty combination haunted the globaleconomy, leading many to argue that the world hadreached its limits of growth and prosperity.Could it bemaking a comeback? Its worth comparing the earlier episode of stagflation with current circumstances inorder to find our way.

Today's world economy does seem to be playing some similar tunes. More broadly, economists are concernedthat if oil prices stay high this year, they could slow the already fragile global economic recovery. As a generalrule of thumb, every USD 10 increase in the price of a barrel of oil reduces the growth of the gross domesticproduct by half a percentage point within two years. As oil prices are entering a dangerous zone, this couldimperil a already fragile economic recovery.

What is stagflation?: remember the 70s

Stagflation is the combination of inflation and recession - an economy which begins to shrink while pricesstill continue to rise. The concept is notable partly because,in postwar macroeconomic theory, economistsgenerally argued that the two were mutually exclusive - inflation would occur when the economy was strong,while a recession would cool inflationary pressures. But these relationships no longer seem to hold in either direction during stagflation. Inflation seems to feed on itself. People begin to expect continuous increases in theprice of goods, so they bought more. This increased demand pushes up prices, leading to demands for higher wages, which pushed prices higher still in a continuing upward spiral. Labor contracts increasingly come to


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include automatic cost-of-living clauses, and the government begins to peg some payments, such as those for Social Security, to the Consumer Price Index. While these practices help workers and retirees cope with inflation,they perpetuate inflation. The government's ever-rising need for funds expands the budget deficit and leads togreater government borrowing, which in turn pushed up interest rates and increased costs for businesses andconsumers even further. With energy costs and interest rates high, business investment languished andunemployment rise to uncomfortable levels.

Economists offer two principal explanations for why stagflation occurs. First,stagflation can result when theproductive capacity of an economy is reduced by an unfavorable supply shock, such as an increase inthe price of oil for an oil importing country . Such an unfavorable supply shock tends to raise prices at thesame time that it slows the economy by making production more costly and less profitable. Second,bothstagnation and inflation can result from inappropriate macroeconomic policies . For example, central bankscan cause inflation by permitting excessive growth of the money supply, and the government can causestagnation by excessive regulation of goods markets and labor markets. Both types of explanations are offered inanalyses of the global stagflation of the 1970s:it began with a huge rise in oil prices, but then continued ascentral banks used excessively stimulative monetary policy to counteract the resulting recession, causing arunaway wage-price spiral.

The first stagflation was overcome at very high cost, including 15 years of slower global growth. While the worldeconomy expanded by about 5.1% during the period 1960-73, it grew by a much slower 3.2% during the period197389.A lot of the slowdown had to do with the worldwide profit squeeze and restraint on investments, jobs, and growth caused by tight energy supplies . A side effect of rising oil prices was to heighten financialturmoil, since central banks around the world, including the Fed, initially tried to use monetary expansion toovercome the supply side constraints.The result was inflation rather than a restoration of economic growth .That is a key lesson for today, at a time when the Fed seems intent on lowering interest rates despite fast risingcommodity prices. There are limits to what a central bank can do in the face of a severe resource squeeze. Thefirst episode of stagflation opened a great debate about the global adequacy of primary commodities, especiallyenergy and food.

Why 2011 may (not) be different

The similarities with the first half of the 1970sare scary. Then as now, the world economywas growing rapidly, around 5% per year 1, inthe lead-up to surging commodities prices.Then as now, the US was engaged in a hotlyunpopular, and unsuccessful war (Vietnam),financed by large budget deficits and foreignborrowing2. The Middle East, as now, wasracked by turmoil and war, notably the 1973 Arab-Israeli war 3. The dollar was in free fall,pushed off its strong-currency pedestal byoverly expansionary US monetary policy. Andthen as now, the surge in commodity priceswas dramatic. Oil markets turned extremelytight in the early 1970s, not mainly because of the Arab oil boycott following the 1973 war, but because mountingglobal demand hit a limited supply. Oil prices quadrupled. Food prices also soared, fueled by strong worlddemand, surging fertilizer prices, and massive climate shocks, especially a powerful El Nio in 1972.

1 Global economic growth is assumed at a 3.4% average growth rate for 2011-2020. Continued high growth rates inemerging market countries, such as China and India, and a return to strong growth in other developing countries underpinworld macroeconomic gains.2 Today, the US is till engaged in Afghanistan and the circumstances in Iraq are not still stable.3 From Tunisia to Egypt, a number of nations in North Africa and Middle East have social and political revolutionary unrest,today.


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Here we go again. Just as in 1972, the recent run-up in food prices is aggravated by climate shocks.In 2010, reports of a sharp decline in wheatharvests in parts of the former Soviet Union -Russia, Ukraine, and Kazakhstan- and Canada ledto a spike in wheat prices in the second half of theyear. In the wake of considerable crop damage in2010 (floods in Pakistan, China, and India, anddrought and wildfires in Russia), subsequent traderestrictions and continued investor interest,agricultural commodity prices are expected toremain strong in 2011.

The last recent escalation in unrest in the MENAregion has finally tipped equities into the longawaited correction. Brent and WTI prices have

both responded aggressively to the worseningMENA news flow. In fact, the move from roughlyUSD 95 Brent at end January to the USD 120 level was driven by increasing supply concerns stemming frompolitical unrest in most of the MENA countries. Note that Brent and WTI prices are now respectively up 104% and76% from their 2009 lows. However, the bulk of this uptrend move was driven by upgrades to the global growthoutlook. Indeed, historically the correlation between oil prices and the economic momentum has been positive,where WTI actually lagged IP growth by a few months. The near term direction of the oil price will remain hostageto geopolitical developments, but unless the unrest spreads to the more strategically important countries, thefurther oil price uptrend move might not need to be dramatic. The concern is over how much could the oil spikehurt the economic activity.

An New York Times article4 discussing the

impact of higher oil prices on the economy toldreaders that: "as a general rule of thumb, everyUSD 10 increase in the price of a barrel of oilreduces the growth of the gross domesticproduct by half a percentage point within twoyears." More, recently we have heard Nomurapredict oil could hit USD 220 if oil supplies from Algeria where to go off line. Oil could hit USD220 a barrel if "Libya and Algeria were to halt oilproduction together," analysts at Nomurainvestment bank predicted. Such a shock wouldreduce OPEC spare capacity to just 2.1 million barrels a day, levels similar to those seen during the first Gulf War and in 2008, when prices hit USD 147 per barrel, they wrote. If the supply disruption and the resulting price actionwhere to mirror 1990-91 then we could see USD 220 a barrel within a couple of months, according to the analystin Nomura, who also warned that speculation could make that price even higher.

When analyzing the JP Morgan graph, we see that, following the collapse in demand for crude oil in 2008,demand started to rise again gradually,and as the economic recovery gathered pace, oil demand began tooutpace global supply in the summer of 2010. There have been many comparisons of this to the 2006-2008period when oil prices reached a record USD 145 per barrel, creating considerable demand destruction andcontributing to the descent into recession. It is true that between 2006 and 2008 when oil prices were increasingrapidly, demand almost consistently outpaced supply, butthe key difference between then and now is thehigher inventory position and Saudi spare capacity . Global inventories currently stand at 2.70 bn barrelscompared to 2.55bn when the oil price hit its peak in June 2008, a difference of 150mn barrels Saudi Arabia has

4 www.nytimes.com/2011/02/24/business/energy-environment/24oil.html?_r=1&ref=world


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3.5mn barrels per day of spare capacity vs. 1.5mn in 2008. Libya accounts for 1.4mn barrels per day, 2% of global supply. This means that even if Libyan production remains offline for a sustained period, OPEC can morethan cover the loss of supply. In addition, OECD strategic reserves contain another 1.5bn barrels which in anemergency supply shock situation can be released.

It is clear that conventional oil supplies will remain tight in the years ahead. New discoveries will not suffice.Discoveries and production increases outside the Middle East rose only modestly and now in many cases are indecline in such fields as Britains North Sea and Alaskas North Slope, according to experts.Few good news arecoming from Africa, however. Indeed, the International Energy Agency, as part of its 25-year New PoliciesScenario, has noted that20% of the worlds total oil production in 2035 will come from sources that had yet to befound, including those in Africa. The continents proven oil reserves have grown since 1989, spiking from 59.1 bnbarrels to 127.5 bn barrels, an increase of a 116%.Currently, Africas net oil exporters include Algeria, Angola,Cameroon, Chad, Democratic Republic of the Congo (DRC), Republic of Congo, Equatorial Guinea, Gabon,Libya, Nigeria and Sudan. Of these countries, Libya, Nigeria and Angola hold the largest proven reserves.Considering other African oil producers is proving increasingly important, particularly with new oil finds incountries such as Ghana and Uganda. Other African countries were deemed to hold cumulative proven reservesof approximately 600 million barrels, which is already said to be understated. Somalia, alone, is estimated to hold

reserves of around 4-bn barrels. The list of new and emerging producers currently includes Ghana, Kenya,Liberia, Mozambique, Niger, So Tom and Prncipe, Sierra Leone, Somalia, Tanzania and Uganda.

Futures markets are no more pricing now for avirtual certainty of substantial supply disruptionsin the next few months and starting to force abrutal recessionary reduction in demand tomeet them. Monday, February 28, 2011, theNYMEX WTI Crude Oil for April delivery closeddown USD 0.91 at USD 96.97 per barrel5.

Coming back to similarities and/or differences,

the 70s period is also described as one of malaise. Among the causes of this malaisewere the Vietnam War, which turned out to becostly, economically, for the US, the 1973 oilcrisis and the fall of the Bretton Woods system.The emergence of newly industrializedcountries increased competition in the metal

industry, triggering a steel crisis, where industrial core areas in North America and Europe were forced to re-structure. The 1973-1974 stock market crash made the recession evident.

The late 2000s recession and financial crisis

As during the 70s, there was a severe global economic recession that began in the US in December 2007 andended in June 2009. This recession has affected the entire world economy, with higher detriment in somecountries than others. This recession has resulted in a sharp drop in international trade, rising unemployment andslumping commodity prices. It was also characterized by various systemic imbalances and was sparked by theoutbreak of the 2007 to present financial crisis. In July 2009, it was announced that a growing number of economists believed that the recession may have ended. However, in the US, the requisite two consecutivequarters of growth in the GDP was not confirmed until the end of 2009.

The financial crisis from 2007 to the present is considered by many economists to be the worst financial crisissince the Great Depression of the 1930s. It was triggered by a liquidity shortfall in the US banking system, andhas resulted in the collapse of large financial institutions, the bailout of banks by national governments, anddownturns in stock markets around the world. The financial crisis is linked to reckless lending practices by

5Oil Price to Reach USD 350 in Near Future. http://www.newsoffuture.com/oil_price_in_near_future_peak_oil.html.


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financial institutions and the growing trend of securitization of real estate mortgages in the US. The US mortgage-backed securities, which had risks were marketed around the world. A more broad based credit boom fed aglobal speculative bubble in real estate and equities, which served to reinforce the risky lending practices. Theprecarious financial situation was made more difficult by a sharp increase in oil and food prices. The emergenceof Sub-prime loan losses in 2007 began the crisis and exposed other risky loans and over-inflated asset prices.With loan losses mounting and the fall of Lehman Brothers on September 15, 2008, a major panic broke out onthe inter-bank loan market. As share and housing prices declined, many large and well established investmentand commercial banks in the US and Europe suffered huge losses and even faced bankruptcy, resulting inmassive public financial assistance.

The EM countries as the new greedy nations

The global economy is entering the second year of an expansion phase, following the sharp recession of 2008.That expansion continues to be led by strength in emerging market domestic demand, while demand growth inmature economies remains lackluster. Unfortunately, the second year of this expansion (mid-2010 through mid-2011) is liable to be significantly weaker than the first year, in part reflecting normal cyclical patterns such as thefading in the boost from inventories. It also reflects the withdrawal of some stimulus policies enacted in 2008-09

to lift the global economy out of recession (e.g. Chinas credit easing and US fiscal stimulus), as well as moregeneral fiscal tightening underway by governments concerned to signal a medium-term limit of the current rise intheir public debt-to-GDP ratios.

Nevertheless, the emerging world will provideagain the principal support to global demand in2011. Most emerging markets, indeed, havebeen experiencing a vigorous recovery, which

has taken output above levels reached beforethe crisis. But, with the rapid growth of theemerging markets, the global economy isexperiencing a seismic shift. We are now into aworld where global growth will be powered byemerging economies, rather than held back bythem. On average, annual world growth isprojected to be accelerate towards 3%compared with growth of just over 2% in the2000s, according to estimates. The EM growthwill contribute twice as much as the DM toglobal growth over this period.


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Remember that in 2003,Goldman Sachs argued that theeconomic potential of Brazil,Russia, India, and China (BRIC)is such that they could becomeamong the four most dominanteconomies by the year 2050.These countries encompass over 25% of the world's land coverageand 40% of the world'spopulation. Goldman Sachspredicts that China and India,respectively, will become the

dominant global suppliers of manufactured goods and services, while Brazil and Russia will become similarlydominant as suppliers of raw materials. It should be noted that of the four countries, Brazil remains the onlynation that has the capacity to continue all elements, meaning manufacturing, services, and resource supplyingsimultaneously. Cooperation becomes thus the logical step among the BRICs as Brazil and Russia together form

the logical commodity suppliers to India and China. Thus, the BRICs have the potential to form a powerfuleconomic bloc to the exclusion of the modern-day states currently of G8 status According to a last report fromGoldman Sachs, China might surpass the US in equity market capitalization terms by 2030 and become thesingle largest equity market in the world.

By 2020, US GDP might be only slightly larger than China's GDP. Together, the four BRICs may account for 41%of the world's market capitalization by 2030, the report said. Note that due to contraction of Japan's GDP in Q410by 1.1% from the previous quarter, so China's GDP surpassed Japan's GDP by USD 5.88 trillion and USD 5.47trillion respectively and make China as Number 2 in world economy.

There is also the issue of population growth. According to estimates, since the four big EM economies of theBRIC are developing rapidly, by 2050 their combined economies could eclipse the combined economies of the

current richest countries of the world. These four countries, combined, currently account for more than a quarter of the world's land area and more than 40% of the world's population.

Global GDP is expected to grow 4.4% in 2011 (vs. 5% in 2010). In 2010, the EM GDP grew at 7.2% compared to just 2.5% for the DM. In 2011, EM economies are expected to deliver 6.1% of GDP growth against 2.6% for theDM ones. Developing Asia continues to grow most rapidly, but other emerging regions are also expected tocontinue their strong rebound. Notably,growth in sub-Saharan Africa is expected to exceed growth in all other regions except developing Asia. This reflects sustained strength in domestic demand in many of the regionseconomies as well as rising global demand for commodities.

The greenback in the aftermath of QE

As during the 70s,the dollar is now very weak as a result of overly expansionary US monetary policy, mainly theQuantitative Easing (QE). QE is this unconventional monetary policy used by some central banks to stimulatetheir economy. The central bank creates money which it uses to buy government bonds and other financialassets, in order to increase the money supply and the excess reserves of the banking system; this also raises theprices of the financial assets bought (which lowers their yield).

The ultimate goal for QE, or any stimulus measure for that matter, is to increase GDP growth and lower theunemployment rate. By design, QE reduces tail risk and fosters an environment for growth, by accomplishing thefollowing: (i) Increasing inflation expectations. This reduces the tail-risk of deflation ; (ii) Reducing real rates. Thisadds stimulus as the real cost of borrowing falls, making it more attractive to borrow and re-lever. (iii) Creatingasset inflation. A reduction in real rates may cause investment to shift toward risky assets. (iv) Causingcompetitive devaluation of the currency.


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The US Fed is responding to the weakness in the US labor market and very low readings of core inflation bykeeping monetary policy highly expansionary. The Fed held between USD 700-800 billion of Treasury notes onits balance sheet even before the recession. In late November 2008, it started buying USD 600 billion Mortgage-backed securities (MBS). By March 2009, it held USD 1.75 trillion of bank debt, MBS, and Treasury notes, andreached a peak of USD 2.1 trillion in June 2010. In early November 2010, it announced an expansion of itsprogram of quantitative easing (QE2), as it plans to buy an additional USD 600 billion of US Treasury bondsbetween November 2010 and mid-2011 (a rate of around USD 75 billion a month). It will also continue to reinvestthe principal repayments of maturing Agency debt and mortgage-backed securities in its portfolio. In total, thisadds up to between USD 850 billion and USD 900 billion of purchases by the end of the second quarter of 2011.

A critical ingredient to the success of QE is that the market maintains confidence in the Feds ability to control anincrease in inflation just enough to reflate asset prices but not so much that it erodes the value of the assets. Again, notice that the first casualty of QE is the devaluation of the USD. That can be viewed as a good thing aslong as it is seen as a competitive devaluation that promotes growth.But if QE were to fail to generate the growththe Fed expects, then devaluation would effectively de-rate risky assets such as equities. In the end, QE is a toolused to treat the symptoms of slow growth and low inflation but it is not the cure. In other words, QE is anattempt by the Fed to cultivate a better environment for growth, and if it were to work, it would have positive

knock-on effects on the broader economy. But if it were not to work, risky assets would surely suffer.In 2011, the ECB, Fed, BoJ and BoE should all remain in easy money mode, while major emerging marketeconomies China, in particular are in the fight of their lives to put down potential asset and credit bubbles andoverwhelming capital flows from the virtually non-yielding developed.The ECB has held out against implementingQE, although it has purchased covered bonds, and since May last year it has been buying (and sterilizing)purchases of Greek, Irish and Portuguese debt in an attempt to stabilize peripheral euro zone debt markets.TheECB is also providing large amounts of liquidity to the region's banks, and is expected to continue doing so in2011. If conditions in peripheral euro zone bond markets do not become less stressed in 2011, the ECB maybegin large-scale government bond purchases6.

My view is that theUSD

offers limited upsidepotential and shouldremain in range-tradingmode during this year,as measured by thetrade-weighted DXYindex. The combinationof loose monetary policyand a lack of a mediumterm plan to reduce theUS fiscal imbalances willlikely result in a weakUSD, even if the growthoutlook proves to besurprisingly strong.Renewed bouts of riskaversion will likely be arecurring theme in 2011and will help to limitdownward pressure on the USD. Looking at the chart, I see the dollar capitulation index in a downtrend, indicatingfurther weakness ahead. Nevertheless, this weakness seems getting old, and entering a short dollar position atthis point might be a risky bet. Watch the momentum indicators.

6 The Bank of Japan announced its own, much smaller, QE program in early October, while some members of the monetary

policy committee of the Bank of England have been arguing in favor of expanding the UK's QE program.


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Global inflation Outlook

In recent weeks, inflation fears have become more pronounced, with consumer prices increasing in advancedand emerging countries alike. In the developed world, with the exception of UK and Spain, inflation is still below3% in most advanced economies. In UK, inflation stood at 4% in January. Over the last six months, inflation hasaccelerated in UK, Canada and Spain, while it decreased slightly in Switzerland and Australia. US inflation hasaccelerated slightly, but remains low at only 1.6%. Rate hikes are therefore rather unlikely.

In the emerging world, inflation, over the last six months in Brazil has increased to 6% despite relatively highinterest rates. This exceeds the historical average by about 1.3 standard deviations and is well above the centralbanks 4.5% inflation target. Inflation has also accelerated and stands at levels above historical average in SouthKorea, Poland, Singapore and China. These countries have already raised policy rates within the last six months.In India, inflation (9.5%) remains slightly above average, even though it decreased by 4% over the last sixmonths. Russia has historically endured comparably high rates of inflation. Over the last six months, inflation hasrapidly increased to 9.6%, which is still below its seven-year average. Inflation and growth in the emerging worldare likely to persist at levels higher than in the developed economies over the coming economic cycle, mainly dueto the impetus of rapidly rising food prices.

Turmoil in the MENA region has pushed oil prices high enough to materially raise global inflation forecast. Aspreviously mentioned, oil price increases have been associated with economic downturns in the past. Accordingto JP Morgan, a 20% rise in crude oil prices, roughly the recent move in Brent crude from its Q410 average

should shave 0.25% off annualized global growth during H111.


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In one of my previous note (High commodityprices are here to stay), I highlighted volatility inthe oil prices but was not expecting further priceincreases. Indeed, my call is for crudefutures to average nearly USD 90/bbl nextyear, with spikes above USD 100/bbl likely.Libyan oil production is near zero but thecombination of Saudi spare capacity (3.5 millionbbl/day) and OPEC has over 4 million barrelsper day of surplus capacity, more than 2.5million bpd even if Libyan production was lostentirely.

So, is Stagflation really likely?

It seems that conditions are fulfilled to have such economic scenario today . However, today's version of stagflation will only slightly resemble to the 1970s. In 1979, for instance, America's core inflation was rising at

over 7% a year, while the economy grew barely more than 1%. Recent core inflation, at 1% (as of January 2011),is far below the central bank's comfort zone of 2%, while GDP growth is pretty close to the economy's sustainablerate. The euro zone, by contrast, has plenty of stagnation, but - despite the ECB's nervousness - there is littlesign that its inflation is getting out of control.

Just because things are not as bad as the 1970s does not, by itself, give much cause for comfort, however,concludes a very interesting paper by the Economist in 2005. How far history repeats itself turns on two other factors, it adds. The first is central bankers' determination to retain their credibility as inflation fighters. The 1970sstagflation resulted, in large part, from extended periods of loose monetary policy pursued to accommodate thedemand-weakening effect of oil shocks by printing money. The credibility-obsessed folk at the central bankstoday clearly have no intention of repeating that mistake.

The other wild card combines labor costs and productivity growth. In the 1970s, productivity growth fell sharplyand unexpectedly7. Added to this, strong trade unions, little international competition, and those accommodatingcentral bankers created a pernicious wage-price spiral. There is little of this dynamic today. Although productivitygrowth has slowed from its recent peaks, it has not slumped. Global competition has left little room for excessivewage demands. This suggests that a return to classic stagflation is unlikely.

Today, higher oil prices eliminate upside risk on global growth, for the moment. Central banks are not unlikely toreact to higher oil inflation. But, the Fed Chairman said that the surge in oil and other commodity prices probablywont cause a permanent increase in broader inflation and repeated that borrowing costs are likely to stay low.Experience with such price gains in recent decades, along with currently stable labor costs, suggests atemporary and relatively modest increase in US consumer price inflation, Bernanke said. He reiterated the Fedsoutlook that while growth will accelerate this year, he still wants to see a sustained period of stronger jobcreation. The comments suggest the Fed will stay on course to complete USD 600 billion of Treasury purchasesthrough June in a bid to reduce an unemployment rate persisting at 9% or higher for almost two years.

In the Euro zone, the ECB has decided to keep interest rates at a record low as oil-price shock that is drivinginflation beyond the banks limit, is also threatening to damp economic growth. Investors last week increased betson the ECB raising rates as soon as August 2011. The ECB must also balance those inflation concerns againstthe risk of exacerbating Europes sovereign debt crisis by removing stimulus too soon. The ECB will probablyraise its 2011 inflation estimate (more than 2% from 1.8%?)and may conclude that risks to the outlook havemoved to the upside.

7 The US nonfarm labor productivity increased at a 2.6% annual rate during Q410. From Q409 to Q410, productivity in the

US increased 1.9% as output rose faster than hours. Annual average productivity increased 3.9% from 2009 to 2010. Unitlabor cost (ULC), in turn, fell 0.6% in Q410. ULC edged down 0.1% from the same quarter a year ago. The annual averageindex of unit labor costs declined 1.5% from 2009 to 2010.


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My asset allocation

Metals, crops and fuel beat stocks, bonds and the dollar for a third straight month, the longest stretch since June2008, as inflation lifted cotton and cocoa and investors speculated violence in the MENA zone will restrain energysupplies. The S&P GSCI Total Return Index of 24 commodities gained 3.8% in February and rose for a sixthconsecutive month, the longest streak since 2004, data compiled by Bloomberg show. The MSCI AC World Indexreturned 3% including dividends, while corporate and government bonds rose 0.21%, according to Bank of America Merrill Lynchs Global Broad Market Index. The USD Index, a gauge of the currency against sixcounterparts such as the euro and yen, fell 1.1%.

Faster global growth pushed up raw-material prices since September and gains accelerated after riots toppledleaders in Egypt and Tunisia and threatened Libyas Muammar Qaddafi. At the same time, central banks inemerging economies mainly, in the BRIC, are raising interest rates and boosting reserve requirements at banksto fight inflation, holding back equities.

So, soaring oil prices, driven by upheaval in the MENA zone, falling equities and elevated volatility continue to

make investors uneasy.Is this changing our asset allocation ? Note thatglobal asset allocators , the universeof investors captured by the Merrill Lynch fund manager survey, wereat the beginning of February, at their most extreme equity OW and very close to their most extreme bond UW since the survey began 2001 .Hedge Funds and Pension Funds also moved away from fixed income into equities and alternatives.

Yes, this shift away from bonds into equitiesmay likely fade on geopolitics, risk aversion,and weakening economic momentum. But,whilemany have been capitulating on a call for a correction, as the uncertainty over where theoil price will ultimately settle remains high,I donot believe we should be cutting equity

exposure . In terms of growth impact, the oilprice would need to spike much further in order to generate an equity unfriendly growthbackdrop. Thus, I continue to find the backdropfor stocks constructive: manufacturingmomentum is reaccelerating and there isevidence of recovery broadening to small

businesses, labor market and credit activity.

So, my top performers for 2011 remain equities over bonds and investment grade corporate over sovereignbonds (Look at my global ETF portfolio model allocation and performance. Data are as of March 5, 2011). But doinclude commodities (will the Brent break well over USD100 for long?) on tight supplies and their gooddiversification value against certain inflation and political risks. On alternatives, I would be buyer of equitylong/short, convertible arbitrage,and secondary buyout private equity(mainly frontier market relatedones). Prefer wheat, soy complex,and copper. I close the long in Brentand open a long in gold. I diversifyaway from USD and EUR for alternatively better EM currenciesthat offer better strong growthand/or fiscal profile in 2011. My keytheme for 2011 remains to favor cyclicals (Tech, Hotels, Autos, Mining) and I advise adding further to thesepositions in light of their recent weakness. Rising geopolitical and inflation risks also favor an OW in Commoditysectors and an MW in EM equities in a global portfolio.


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Data are as of March 5, 2011.

My global regional allocation

Economic momentum and positive valuations imply DM should outperform EM, mainly in medium term. Indeed,slightly weaker EM indicators (China PMI, Brazil IP) contrast with upside surprises in advanced economies (USPMI). In EU, the PMI and ISM manufacturing surveys continued to improve, which supported the overallimprovement in risk appetite.

The EM super cycle story remains intactas this is where we will experience the highest top line and earningsgrowth led by higher GDP growth. However,the combination of a rebounding dollar , massive long positions incommodities, and monetary consolidation due to inflationary pressures in the EM may make the risk/rewardprofile for EM relative performance to global equities, especially US stocks,vulnerable. Also,EM inflation worriesand a narrower growth gap with DM keep us favor DM vs. EM equities.So, keep an eye on the greenback backsupremacy, mainly during volatile periods. We suggesta neutral allocation in emerging markets in a global equityportfolio for now.

References

Sachs Jeffrey (May 28th, 2008): Stagflation is back. Heres how to beat it,http://money.cnn.com/2008/05/27/news/economy/sachs_stagflation.fortune/index.htmThe Economist (June 21st, 2011): Stagflation? As growth slumps, inflation jumps, www.economist.com/node/666376The Economist (May 5th, 2005): Stagflation, the remix, www.economist.com/node/3941024.


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Is Stagflation Back?

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research and service, by establishing strong and iific needs by offering investment decision-makinorizon.

n of an entrepreneurial firm with the analyticae highest levels of client service.

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and consultancy firm,

ideas to investmentmarkets in particular,

l and cyclical themestilizing rigorous andarket experience to

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teractive relationshipg process that match

l rigor of a research

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