At best, the rise in global inflation will mean no further interest rate cuts during this cycle but at worst it may mean a rise in interest rates over the short term at a time when economic growth is softening in many countries. 83% of all countries in the world have higher inflation than 3 months ago (as at the end of March) *

[The end game for inflation, in our minds, is the difficulty Anglo-Saxon economies will have in financing their current account deficits as inflation should keep rising until we reach breaking point. All in all, inflation is a pretty nasty thing.

Since HSBC published its last quarterly Investment Outlook, we have grown more cautious on the back of a deteriorating growth outlook and inflation rearing its ugly head.

We have maintained our negative stance on Europe where growth prospects are rather gloomy.  The Eurozone suffered the most significant downgrades in sentiment worldwide over the last quarter due to the tight credit conditions and unexpected increase in wage inflation. We are avoiding financial and consumer sectors such as auto, food and retail.

Whilst EM earnings growth looks strong relative to its developed market counterparts and the region has had little exposure so far to the subprime crisis, the EM is far more exposed to today’s inflationary concerns and still contingent on G7 consumers.

On average a 1% reduction in G7 consumption implies approx a 15% decline in EM exports – as such these markets are not fully immune from the rest of the world, even if the shock will come with some lag. EM countries are also on average more sensitive to food, oil and energy prices than developed markets. As there prices rise, they act as a tax on consumers and companies that may restrain a continued upside. As a result, we believe oil exporting countries will continue to post both vigorous growth and inflation rates.

Accordingly with the emerging market decoupling story coming under increasing pressures, we have moved emerging market debt to negative from neutral. At the same time, we have reduced risks in our equity views and have moved to a neutral outlook on emerging market equities [as at 22nd May] after having been key supporters of the EM story for the last few years and have moved to a negative outlook on Asian emerging markets.

With heightened risks in the EM, we favour countries that are better protected from inflation, most notably net exporters of crude, such as Russia and sectors such as technology and oil and gas.

North America is the only positive play albeit with a low conviction level. We like the US on a 12-month view due to the strengthening dollar, more stable corporate earnings and due to being more progressed along the recessionary path relative to other countries. We anticipate a ‘w-shaped’ recovery and favour large-cap growth, with an emphasis on quality companies and are overweight IT and Energy.

As this volatile scenario plays out, we believe hedge fund managers are best placed to take advantage of swings. In real estate markets, we focus our attention to emerging markets where urbanisation trends and infrastructure investments are more supportive.

On the currency front, we expect a strengthening US dollar. In particular, we believe that greenback strength will develop versus EUR and JPY as the Federal Reserve shifts its focus away from growth towards inflation.

With rising inflationary concerns around the world, one thing is clear: sovereign bonds are still overpriced. We believe these offer limited value given low or even negative real yields. Hence, we prefer to allocate to high quality corporate bonds.