Who would be a Central Banker these days? Besieged by economists offering contradictory and highly public advice on a daily basis and with fiscal policy hostage to the electoral cycle, these guardians of the public punch bowl have an unenviable task. The slightest tweak to an irrelevant liquidity measure or interest rate, be it the Chinese Reserve Requirement or the US Discount Rate, is pored over by the World’s markets as a possible precursor to a major tightening cycle, while even more immaterial changes of adjectives in a monthly commentary are accorded an import out of all proportion to the likely reason for their usage. Yet there is good reason for the market’s current level of hyper-sensitivity. It has been a recent article of faith that we could count on both low interest rates and a respectable economic recovery throughout 2010. A rebuilding of inventory and a resumption of private sector hiring would spur demand while the output gap would ensure that we would not have to worry about any pesky inflation for the foreseeable future. Unfortunately, this economic Nirvana will have to wait.

The reality is that the choice facing policy makers is stark indeed. Tighten now, either fiscally or monetarily, and precipitate a double dip recession – OR – retain the ultra-accommodative and fiscally lax status quo and wait for the markets to assume that you are the next Greece or Dubai, in which case the markets do the tightening for you and precipitate the double dip. (To be fair to the UK, we think a double dip is less likely than elsewhere in the OECD, but only because we never got out of the first one). We are already starting to see the impossibility of reducing enormous budget deficits in an environment of high unemployment and high existing debt. Job losses in the Public sector merely become higher benefit payments while depressing consumer demand further, increased capital requirements for banks reduce lending capabilities and thus growth, increased taxes discourage private sector job creation and encourage avoidance (as certain high profile Private Equity executives, if not their families, could attest). It would probably be easier to manage in a dictatorship, but in a democracy we can’t cope with the pain involved in rolling back several decades of rapidly rising standards of living, even if it is increasingly obvious that this was a debt-induced chimera.

So what is the prognosis? Stagflation in the West looks like a slam-dunk to us. Anecdotally we see little evidence of the output gap depressing prices, and given the longer-term demand profile for commodities both hard and soft in the increasingly populous and wealthy East, would expect cost-push inflation to rear its ugly head over the next few years. Stronger Asian currencies are likely to push the costs of manufactured goods up as well. This does not bode well for sovereign debt markets, which will continue to suffer under an avalanche of issuance which must increasingly be skewed towards the longer end of the curve. Corporate debt will fare little better in an environment of rising long rates and a crowding out of the private sector. We suggest a portfolio orientated towards domestic Asian assets, index linked securities and precious/rare commodities.

The words ‘China’ and ‘bubble’ now seem like a phonetic set of Siamese twins if recent press coverage is anything to go by. Pictures of brand new, empty buildings are accompanied by a text comparing the Chinese investment boom to Japan circa 1989 or Dubai circa 2008. What is less newsworthy, but more important, is the enormous (and necessary) upgrade to public transport and a determined effort to upgrade the efficiency and environmental performance of heavy industry. A $5bn bridge to a village of a few thousand inhabitants is a Japanese-style bridge to nowhere. The same bridge in China probably connects two cities of a million plus inhabitants, and is likely to have economic value beyond the construction labour. Crucially, these investments are not funded on unsupportable debt or the premise (as in Dubai) that a ski slope in the desert would catalyse a productive business centre. We vividly remember our first trip to Shanghai in 1987 when we stood on the Bund and looked at Paddy Fields across the Huangpu River. The Mayor showed us his plan for what he hoped would be a financial centre with one hundred skyscrapers – and they WERE building a bridge to an area with virtually no existing roads. Yet they built it, and they did come. This is not to say that China can continue to grow on fixed asset investment alone – policymakers and investors alike realise that much more needs to be done in rural areas and in ‘soft’ infrastructure such as healthcare and education. But to simplistically assume that there has to be an economic implosion after an infrastructure boom is based on a premise of false comparison. 1.4 bn people aspiring to a Western standard of living from a base of $6,000 per capita GDP soaks up a lot more investment than a shrinking Japanese population of 100m with a 1989 per capita GDP of circa $50,000. Will there be some bad debts to write off for Chinese banks after the recent lending splurge? Of course – but as they are instruments of state policy this is not a systemic concern. Should we invest in Chinese Banks? We prefer not too. Yet the economy is on a much sounder footing than most others in the world, and while we are less bullish in the near term on market valuations than Mr. Bolton, we do not view the economy as a fly waiting for a windshield on the freeway.

January has been a busy time for official interference in the region’s property markets. Thailand has removed the tax breaks introduced a year ago as the market has recovered, Hong Kong is likely to introduce a slightly higher stamp duty for luxury apartments over US$ 2.5m, Chinese authorities are becoming more aggressive in enforcing their ‘use it or lose it’ policy for landbank and Singapore has introduced a seller’s stamp duty for speculators and further reduced the maximum Loan To Value (LTV) that the banks can extend. Regulators are clearly ‘on the case’ of lancing perceived incipient property bubbles, but in nearly all cases (so far, at least) the changes make little or no difference to the underlying supply/demand or affordability of the market. They have, however, impacted sentiment on the listed real estate plays, and discounts to NAV are looking attractive at the same time as the physical markets are showing resilience in the face of these new regulations, with both prices and transaction volumes very healthy. We would cite the recent sales of Island Crest and YOHO Midtown in Hong Kong as examples of the disconnect between investors in the stock market and those focused on the bricks and mortar. We view these stocks as an attractive way to play both domestic consumption in the East and the ongoing economic freefall of the West.

Talk of demographics in a forum such as this is normally because the writer has run out of more pertinent and timely things to comment on, but sadly we can no longer indulge in the luxury of ignoring what happens ten years out. Catalysed by the dire state of Public finances, the debate on how society pays for an ageing and ailing workforce has moved centre stage. Obama is staking a lot of political capital on getting some sort of healthcare reform, while one of the largest insurers raises its prices by 39%. In the UK a debate over a £20,000 ‘death tax’ to pay for care for the elderly has become a prime electoral issue (second only to whether the PM is a ‘bully’, who may also have been caught smoking behind the bicycle sheds), and the share price of BT collapsed over an argument over whether 17 years is too long to plug a pension deficit. Depressing as it is to dwell on these subjects, they are impacting markets today. Once again one only has to look east to see how one can mitigate these potential problems in one’s portfolio.

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