The British economy is struggling but the traders are smiling

“Stagflation” is the buzzword of the day in London, but with over 70 per cent of FTSE earnings comin

The spectre of stagflation is on the horizon in the UK and traders don't know quite what to make of it. January had opened on a hopeful note, with good volumes traded in European stocks (up over 20 per cent on the same time last year), almost €4.5bn of new shares issued and a strong pipeline in equity and credit markets. This optimism was cut short by the UK's shocking GDP figures (a 0.5 per cent drop in the last quarter of 2010).

The dismal scientists have been out in force, explaining exactly why stagflation poses such problems for economists. Inflation can be dealt with: you raise interest rates. But if inflation is twinned with fragile underlying economic conditions, raising interest rates risks scuppering any putative recovery. After the release of the GDP reading, the pound lost almost 1 per cent against the dollar and 1.5 per cent against the euro, falling to its lowest level in more than two months. The FTSE dipped towards 5,900.

By the next day, all was rosy. News that the Dow Jones index had broken through the 12,000 mark for the first time since 2008 sent European stocks higher in sympathy. The FTSE regained all the ground it had lost the previous day. It was another sign of the essentially in­ternational nature of our leading stock index. The good news had nothing to do with the UK: Barack Obama's State of the Union address was deemed market-friendly; earnings in the US have been generally at or above expectation; Shanghai shares bounced from their recent lows and Seoul jumped to the highest level in six weeks. The global picture suggests that the recovery is on course, and given that over 70 per cent of FTSE earnings comes from outside the UK, the bleak local picture should not hamper our share prices.

Going for gold

It seems as if the UK is uniquely positioned, suffering "bad" inflation - inflation that comes from higher taxes and rising global commodity prices, rather than from increased wages and earnings - while also enduring stagnant economic growth. Even if we agree that UK shares have a certain immunity to local economic ills because of their global reach, the uncertain outlook still poses numerous questions for traders looking to position themselves into 2011. If 2010 was about continuing the 2009 recovery and avoiding "contagion" from bank failures and sovereign crises, 2011 will be a story of sailing between the Scylla of inflation and the Charybdis of negative growth, with "stagflation" the buzzword. And it looks as if the UK, which managed to skirt around most of last year's difficulties, will be at the very heart of this one.

Traders know how to deal with run-of-the-mill inflation. Indeed, "good" inflation - the kind brought about by growth in the underlying economy - tends to lift most asset classes with it. Traders keep their cash holdings to a minimum during periods of inflation, given the negative drag of an asset whose purchasing power is being eroded by rising prices. Gold is the investment of choice. John Paulson, a hedge-fund superstar, launched a gold fund in late 2009 that has performed spectacularly. Gold rose from just under $1,000 an ounce to over $1,400 in 2010. But all commodities rise in an inflationary environment, from palladium to oil to wheat. Trading successfully when inflation is running at a high level is a matter of relative performance - selecting those asset classes that will inflate at the fastest pace.

Naturally, there are stocks that are inherently exposed to inflation - mining, oil companies, high-end retailers. Most traders would take fixed income (bonds) underweight in their portfolios, given the negative relationship between interest rates and bond prices. One exception to the rule that we should avoid fixed income would be bonds whose coupons are specifically linked to inflation. In the US these are known as "treasury inflation-protected securities"; in the UK they are called "inflation-linked gilts" and are tied to the Retail Prices Index. NS&I, the Treasury-backed savings bank, took its inflation-linked bonds off the market in July last year but BM Savings, a subsidiary of Lloyds, has just issued a similar bond that will be open for subscription until early March.

Blip or double dip?

In short, there are various ways for traders to hedge against inflation and still generate attractive returns. The picture for stagflation is far less clear. While inflation-linked bonds still make sense in a stagflationary environment, the availability of these bonds during periods of sustained inflation is limited. In the secondary market, inflation-linked bonds have already become prohibitively expensive. In stagflationary times, gold has a double appeal; not only does its value rise in periods of inflation, but it also benefits as a safe-haven investment in times of uncertainty. So, while some are saying that the gold trade has already played out, and levels will return to the $1,000-an-ounce level as the world economy stabilises, Paulson and other gold mavens are predicting prices of $4,000.

On the stock market, defensive investments are the order of the day, with consumer staples, pharmaceuticals and tobacco companies all showing low correlation with the underlying economy. The rally in the FTSE the day after the release of the GDP figures was led by just such defensive stocks: British American Tobacco, Imperial Tobacco and AstraZeneca all saw significant gains as traders prepared their portfolios for stagflation.

It's not yet clear whether we'll suffer merely "stagflation-lite", or a full-blown double dip, or a brief blip on the road to full recovery. Whatever the case, January's buoyant market conditions have kicked off a 2011 that will be marked by uncertainty and volatility.

Sophie Elmhirst, page 45
Alex Preston's novel "This Bleeding City" is published by Faber & Faber (£7.99)