Recent History and the Re-Rating of Global Equities

History suggests that the current relationship between equity and bond valuations will persist until equity valuations overshoot and/or the cost of capital rises significantly.

In the late 1980s, the junk bond market was the facilitator for the leveraged buyout mania (LBOs), and the equity bull market ran out of steam once this source of capital started to dry up. In the early-1970s and again in the late-1990s, the valuation overshoot lasted much longer than the 1980s. All bull runs ended when capital became less plentiful. Bottom line: The wide gap between the return on equity and price-to-book value should converge before a major bear market arrives - this usually occurs late in the decade when fears of recession finally disappear, and investors extrapolate good times well into the future even though profit margins have long since rolled over.

Bank of England Minutes Indicate Upside Risks for Policy Rates

Another Bank of England rate hike can be expected with a strong possibility of a second.

Yesterday's release of the May 9-10 Minutes, indicted that policy makers voted unanimously in favour of raising the Bank Rate by 25 bps to 5.5%. Several MPC members considered whether hiking 50 bps was more appropriate, highlighting the central bank's concern over the inflation outlook and the need to err on the hawkish side. This, coupled with the unusual degree of uncertainty surrounding the inflation outlook (according to last week's BoE Inflation Report), has complicated matters. Arguably the Bank of England's "wait and see" strategy has resulted in monetary policy falling behind the curve. Rampant broad money growth, a positive output gap, a large deterioration in unit labour costs, rising inflation expectations and Chinese overheating make a strong case for higher interest rates. Any stickiness in inflation, evidence of wage pressures, or ongoing strength in housing and consumption will be met with further tightening. The housing and retail sales data over the past two weeks has been marginally weaker, but the BoE will need evidence of a trend before softening its tone. Bottom line: A policy overshoot (6%) remains a significant risk later this year and asset prices could suffer as a result.  

Will food prices be the next inflation shock?

Empirical evidence from local farmers here in the North support growing concerns about the impact of higher food prices on global inflation. This story made the front page of today's Financial Times. Here are six reasons why fears may be overdone: 

1. The prices of agricultural commodities are already levelling out. The diversion of crops to the production of bio-fuels has reduced the supply to food markets, particularly in the US, but spot prices now appear to be settling down.

2. The rises in prices to date have already been reflected in a marked acceleration of the food price components of CPI inflation. In the UK food price inflation is already running at 6.0%.

3. European consumers will be protected against at least part of the rise in global food prices, which are typically priced in dollars, by the strength of Sterling and the Euro against the US currency.

4. Some other important factors that drove up food prices last year are likely to be more favourable this year. In particular, global harvests are now recovering after a series of weather shocks and natural disasters. The impact of global warming is also not all bad: the lack of frost damage during the unusually mild winter is putting downward pressure on seasonal food prices in Europe.

5. Technological advances should increasingly allow bio-fuels to be extracted from the non-edible part of the crop (the stalks rather than the grains) without reducing supply to food markets. In the meantime, to the extent that bio-fuels do replace conventional energy sources, the impact of any rise in food price inflation on the headline rate will be at least partly offset by lower energy price inflation.

6. Talk of surging Chinese demand to close a 'protein gap' is a red herring. China is not as 'backward' in its consumption habits as many assume. Per capita consumption of meat, for example, is already well above levels in other (much richer) Asian countries, and not far short of that in the UK.

Bottom line: The world's population has been growing rapidly and consuming more food of all types throughout history and yet the long-term trend in (real) food prices is still down, as technological advances have allowed production to keep up with demand.

And finally...... 

A Muslim was seated next to an Australian on a flight from London to Melbourne.

After the plane was airborne, drink orders were taken. The Aussie asked for a rum and coke, which was brought and placed before him.

The flight attendant then asked the Muslim if he would like a drink.

He replied in disgust, "I'd rather be savagely raped by a dozen whores than let liquor touch my lips."

The Aussie then handed his drink back to the attendant and said,

"Me too - I didn't know we had a choice."

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.