Financial market wobbles caused by turmoil in the Middle East have done little to stop investors positioning themselves for a further rally in stocks and other riskier assets as economic growth accelerates around the world.
In fact, rising oil and food prices, the former exacerbated by the unrest in Egypt and Tunisia, are reminding investors of growing inflation risks, which also reinforce the case to buy equities, commodities and other risky assets rather than bonds and money market instruments.
World stocks measured by MSCI erased early losses last week to hit 29-month highs. The benchmark index has risen 3.4 percent since the start of the year and is on track to post its biggest weekly gain in two months.
Risk aversion also proved temporary. The VIX index — Wall Street's fear gauge — fell below 17 percent on Thursday having briefly jumped above 20 late last week.
"Rising energy and food prices have pushed up global inflation in recent months. Since global economic growth has simultaneously picked up, there is a growing risk that this price increase is not just a temporary phenomenon," said Philipp Baertschi, chairman of the investment committee at Sarasin.
"The economic environment for risky assets should remain positive in the months ahead. We are therefore sticking to our slight overweighting of equities. We aim to use any corrections to build up risky assets further."
He said a 5-10 percent correction in stocks was now overdue given the virtual non-stop rally since September 2010, adding that Sarasin favours energy and technology sectors.
Global surveys showed services sector activity surged in the United States and Europe in January, mirroring similar reports about global manufacturing and reinforcing expectations global growth would be at a healthy 4 percent in 2011.
And cash-rich corporates are on a shopping spree, which shows that they are confident about an economic recovery.
Thomson Reuters data shows the value of worldwide mergers and acquisition totalled $309.6 billion so far this year, up 69 percent from 2010 and marking the strongest start for M&A since 2000. Financials, materials, energy and power sectors accounted for almost two thirds of this year's total.
Firms on the S&P 500 index — 58 percent of which have reported fourth-quarter results — expanded their quarterly earnings by nearly 37 percent.
Lipper data shows emerging market equities suffered record net redemptions of $4.1 billion in the week ending Feb 2, although this comes after they attracted hefty inflows in 2010.
Investor risk morale was intact, with U.S. stocks attracting a net $4.11 billion. Investors have also pulled $57.5 billion from money market funds in the past three weeks.
Volatility is expected when Egypt's stock markets reopen in the coming week after the index fell more than 21 percent since the start of the year. But long-term investors still see value in the biggest North African economy.
A growing threat to an otherwise favourable economic outlook is inflation — which is in part a source of turmoil in the Middle East.
Brent oil rose as high as $103.37 on Thursday, its highest since September 2008. Global food prices tracked by the U.N. Food and Agriculture Organisation hit their highest level on record in January, a problem set to worsen after a massive snowstorms in the United States and floods in Australia.
JP Morgan expects a sustained 10 percent rise in oil prices would cut global gross domestic product by 0.25 percentage points.
Mounting price pressures are grabbing attention of policymakers, not just in emerging economies but in the developed world.
In the euro zone, whose inflation is already at a 15-month high of 2.4 percent in January, European Central Bank President Jean-Claude Trichet warned inflation is likely to climb further.
UK inflation stands at an 8-month peak of 3.7 percent in December and Britons' inflation expectations for the year ahead picked up in January to a two-year high, raising expectations that the Bank of England would raise interest rates this year.
Goldman Sachs estimates that at the peak, estimated to be around the third or fourth quarter, food and energy will add to headline inflation to about 160 basis points in the United States, 200 bps in the euro zone and UK and 90 bps in Japan.
While G4 central banks (Fed, ECB, BoE and Bank of Japan) focus on core inflation, higher commodity prices could push inflation expectations higher and increase chances of second-round effects.
However, as long as inflation is under control, the environment remains favourable for risky assets.
Goldman noted that higher commodity prices are driven by a strong bid from emerging economies, where central banks are reluctant to raise interest rates to avoid currency appreciation.
"The irony here is that by focusing on core inflation, the major central banks are 'exporting' looser monetary policy to emerging markets, and as a result, they are being forced to 'import' back higher food and energy prices," Goldman said.
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