The world economy is experiencing two shocks at the same time. On one hand, a housing market-driven credit crunch has triggered a de-leveraging process that is crimping spending across the developed world. On the other hand, rapid growth and rising wealth in the emerging countries are raising the resource intensity of the world economy and exerting a commodity price shock.

The link holding these two forces in delicate balance is the ‘dollar pegs’ in the emerging world, which are exporting cheap US money to these local economies. Real interest rates across the emerging world are mostly negative, creating an environment of excess demand that is seeping back into Western market places through higher import and commodity prices.

Clearly, the most benign outcome will be a revaluation, or even a break, of emerging market pegs that allows fast-growing emerging market countries to run independent monetary policies more appropriate for their economies instead of prolonged periods of negative real interest rates. Higher emerging market currencies will also rebalance demand away from the US consumer towards the emerging market consumer.

However, emerging market central banks have exhibited great reluctance in breaking away from these currency regimes, which have created more than eight years of unparalleled prosperity. Instead, there is a growing risk that real economies will adjust in lieu of their nominal exchange rates.

In other words, higher inflation in the emerging world will lead to an appreciation of the real exchange rate – ultimately rebalancing demand away from exports towards consumption. In countries with weak economic fundamentals, like Vietnam, India, the Philippines, Turkey and South Africa, a rising real exchange rate could threaten the credibility of the central bank and could even trigger currency depreciation.

Wealth is on the move
A monumental transfer of wealth to the petro-economies is under way. Oil and other commodity exporters are clearly the unintended beneficiaries of these opposing global forces. As low US interest rates get exported and the emerging world overheats, commodity prices are getting squeezed ever higher. Resource economies are experiencing a vast improvement in their terms of trade and are reaping windfall gains. On the whole, there is a daily transfer of US$2-2.5 billion from oil importers to oil exporters.

The increase in oil prices from $80 a barrel to $150 a barrel will transfer $74 trillion in wealth from oil importers to producers. To put this in perspective, this wealth transfer equates to almost five times US GDP. The flip side of this transfer of wealth is that resource-importing countries suffer severe adverse terms of trade effects and sizeable windfall losses.

The Japanese economy, after a decade of deflation, should benefit from today’s rising inflation. Japanese interest rates should slowly trend up, with bank profitability being restored and the vast mountain of personal cash deposits held at zero real rates starting to leak back into equities.

Certain defensive industries should be winners – those with little commodity/energy inputs, such as technology or pharma. Other companies with the pricing power to pass the rises on to consumers should be able to deliver inflation-plus earnings, and include selected utilities and global food and tobacco companies.

Finally, anyone who can solve the ‘security of supply’ issues that lie behind today’s food and energy inflation should continue to outperform – strategic commodity producers, and energy equipment and infrastructure stocks.

Historical comparisons for Europe and the US suggest the sort of inflation levels envisaged have not traditionally hurt long-term equity returns. In Europe, valuations are exceptionally cheap, liquidity still generous and balance sheets strong. Regional equities may be cheaper than six months ago, but are still at premiums to Western equivalents.