Global Markets Weekahead: Return of inflation?

By Natsuko Waki

LONDON (Reuters) - Surging oil and commodity prices coupled with a falling dollar are prompting some investors to brace for a return of inflation, which would benefit equities and damage most government bonds. Inflation -- which in the short to medium term benefits equities and risky assets because of rising prices -- had all but disappeared after the global economy fell into recession and commodity prices sank last year.

However, signs of a global economic recovery -- which next week's manufacturing and service sector surveys and other data could reinforce -- are leading to a renewed surge in energy and commodities and the outperformance of inflation-protected debt securities over benchmark government bonds.

Oil prices are nearly double their four-year low in December. The Reuters-Jefferies CRB index, a global commodities benchmark, has hit a six-month high while the Baltic Dry Index, which tracks rates to ship dry commodities, has risen more than 320 percent since the start of the year.

To exacerbate matters, the dollar is on track for the worst monthly performance since December 2008, which could further fuel buying in dollar-based commodities.

The return of inflationary forces at a time the world is grappling with the threat of deflation, could prompt investors to invest in assets such as stocks because rising prices erode the value of cash. Already struggling government bonds, apart from inflation-linked debt, could come under further pressure.

"We're in a reflation trade. Confidence is off its low from March and asset prices are rising. The beneficial period will continue until we find reasons to be pessimistic again," said David Miller, partner and head of alternative investments at Cheviot Asset Management.

"People are getting out of the dollar, into commodities, into equities... Selectively there are reasons to buy commodities in a portfolio."

Miller said while the commodity supercycle might not materialize, crisis-related factors such as the absence of farmers credit are constraining supply and pressuring prices.