LONDON (Reuters) - Inflation threatens to supersede the credit crisis as investors’ biggest enemy later this year as fears of a deep economic downturn recede and commodity prices show no signs of easing.

Inflation threatens to supersede the credit crisis as investors' biggest enemy later this year as fears of a deep economic downturn recede and commodity prices show no signs of easing. REUTERS/Tim Wimborne

Growing relief that the global economy has so far escaped the worst case scenario from the eight-month-old credit crisis has stabilised financial markets. World stocks, as measured by MSCI, are hitting three-month highs and pulling the dollar off its March record low .DXY against major peers.

Many central banks, faced with the twin problem of the credit crisis and rising prices, have cut interest rates to ease the flow of credit, leaving inflation issues for tomorrow.

However, the relentless surge in resource prices from oil to rice and the resilience of emerging economies risks are turning inflation into the bigger worry for policymakers and asset markets.

Japanese inflation, which hit a decade-high in March triggering one of the biggest ever sell-offs in yen bonds on Friday, is a case in point.

“If the global economy has struggled out of the frying pan of the credit crunch, it seems destined to fall into the fire of high inflation ... High inflation is cruel to the owner of financial assets,” said Tim Bond, head of global asset allocation at Barclays Capital.

“Equity markets will rally for a limited period of time on belief that weakness in earnings will be short-lived. Moving into next year, you will see markets come off on the inflation story. Investors who see some of the rise in earnings being driven by inflation generally take the view that’s not sustainable.”

EQUITIES, BONDS UNDER PRESSURE

Bond says during the last inflation crisis of 1970-1980, only a handful of asset classes gave positive real returns, including banks, basic resources, energy and industrial goods equity sectors, physical oil and physical commodities.

During that decade, the S&P 500 index’s price earnings ratio fell as low as 7 from a high of around 18.

Although the picture is distorted this time by the weakness of financial firms, Bond estimates the P/E ratio could fall to around 13 if U.S. inflation expectations fire up.

According to I/B/E/S data, the 12-month forward P/E ratio for the S&P 500 index stands at just below 15, compared with around 16 before August.

Bond says default rates would have difficulty improving because inflation could raise nominal interest rates. Inflation index-linked bonds offer some protection but will share the rise in real yields, bringing negative or low returns on medium- to long-term linkers.

APPLYING BRAKES

The Reuters-Jefferies CRB Index .CRB of 19 commodity markets hit an all-time high this week, up 50 percent since early 2007, driven largely by strong demand from emerging economies.

“The credit crisis is a Wall Street or City problem but commodity prices are the problem in the high street. It will invariably affect both consumer and corporate spending,” said Jeffrey Solomon, managing member of U.S.-based investment firm Ramius Capital.

Rising energy and food costs are already weighing on consumer and business morale, especially in the euro zone where shoppers have started to scale back spending.

Euro zone inflation hit a record high of 3.6 percent in March while Bank of England officials have warned on inflation, which could exceed 3 percent later this year -- both well above the central banks’ target levels. The Fed’s preferred measure of inflation, stripping out food and energy, is running at 2.5 percent.

“Measures of prices are screaming for attention... It is apparent that (U.S. and euro zone) central banks have begun fretting about inflation,” State Street said in a note.

“The job of central bankers is to know when to apply the brakes ... Ideally the economy should come to a smooth halt rather than smashing into traffic or careening off the road.”

Of sectors which typically outperform when inflation expectations rise, State Street says institutional investors are already buying the consumer discretionary sector and flows momentum is improving for industrials, materials and IT.

Flows into consumer staples, utilities and health care -- sectors which typically underperform in times of higher inflation expectations -- have become more negative.