Inflation, deflation or stagflation? In seeking an answer as to where the economy is going, a distinction has to be made between specific events like retailers profiting from the conversion of legacy currencies to euros or the impact of the Iraq war threat on oil prices, and the underlying economic fundamentals. The latter are resolutely pointing towards deflation. In one sense it has already started in the USA. The retail price index is negative 2%, despite a positive overall CPI.

The immediate causes of the deflationary pressures are excess manufacturing capacity and absence of pricing strength by suppliers of almost all products. Demand is weaker than production capacity and bound to remain that way because of the over-indebtedness of both corporations and households. We have often written of the need for rebalancing. Clearly households in the USA have still not seriously begun debt reduction; rather, they are responding to the Administration's policy of putting off the evil day. Corporations have. Data on non-financial corporate debt (i.e. ex-banks and the like) show that a peak in the ratio to GDP was reached in March this year of 48%. Since then the ratio has declined to 47%.

How much further has the ratio to fall before rebalancing may be complete? The previous high was 43% in 1991. After each high, the ratio has fallen by several percentage points, always trending higher but with very large declines in between the peaks. The US GDP is about $ 10 trillion. Taking a likely decline between 5 and 8% suggests a debt reduction in the order of $ 500-800 billion over the next five years or so.

In the meantime, the US Government will be borrowing more to cover its ballooning deficit. However, the level of increased Government borrowing for a deficit increasing at $ 150 billion or so per year looks like it can roughly be covered by the lower rate of corporate borrowing, never mind any future preference investors have for Government bonds. The implications of investments moving from the private to the public sector will only slowly be seen, but the outlook does not look too positive to us.

In Europe, the same trend exists of Government borrowing growing and private debt declining. For example, many convertible bonds will not now be converted and will eventually have to be redeemed at par like a straight bond. A current estimate is for $ 41 billion of redemptions over the next 18 months from the likes of France Telecom, Vivendi and Olivetti. Echoes of the Japanese convertible bond story of the 1970s!

Stephen Roach of MSI, a voice in the wilderness for which we have great respect, blames the Central Bankers for fighting the wrong war (that against inflation) when the real threat is deflation. "Fixated on the inflation targeting of yesteryear, the authorities are unwilling or unable to give active consideration to the possibility of deflation -- a classic by-product of a post-bubble world." An influential voice in the person of Deutsche Bank's Chief Economist, Norbert Walter, is rallying to this view.

Our views are in line with Roach and Walter. Since early 2000 our dominant theme has been that inflation, profits and yields will all be low for this decade. The danger to this scenario is not a return to growth and inflation, but to no growth and inflation, also known as "stagflation".

Obviously not everyone agrees with our scenario. Many want to protect their investments against possible inflation. Accordingly, index-linked bonds are proving attractive to investors as a means to address this fear, and to borrowers because they pay lower rates. (It may also apply that borrowers, both government and corporate, are secretly of the view that the risk of inflation and higher future costs is small!).

Given that all investments are about balancing risks, we agree that there is room in fixed-interest portfolios for a proportion of index-linked instruments. Nevertheless, we cannot yet change our recommendations on average maturities.

Many quality bonds are now trading at significant premiums. Some investors may see this as a good time to take profits and move to newer issues nearer par with current coupons. Holders of Swissair dollar bonds have seen big gains recently as hope rises that the sale of Gate Gourmet will allow redemption at par with accrued interest. However, the couponless wait may be long before cash is collected.

Recommended average maturity for bonds in each currency.
Remain long across the board, except in Sterling.

There are still no signs of a sustained recovery on the horizon, while a lot of uncertainty over Iraq can be expected over the next couple of weeks. A further erosion of investors' confidence in banking assets could choke off credit and give rise to a credit crunch. The US unit recouped some of its losses recently, but the medium-term sentiment leans clearly towards a still lower dollar. In the short term, we expect range trading to continue.

EUR/USD: The range is from 0.9730 to 0.9980. A break on either side would mean a minimum move of 100 points.

USD/CHF: Here the range is 1.4700 to 1.5050. A break on either side would likewise imply a move of at least 100 points.

USD/JPY: Same comment: the bottom of USD has gradually moved higher, and 118.80 has already become a solid support level. Topside is at 120.10, 120.80 and 121.30, while 115.50/117.00 remains the major support area.

EUR/JPY: Same comment: here as well, consolidation is to be expected in a 115.00 to 118.00 trading range.

USD/CAD: The CAD continues to weaken and, if 1.5780 is broken, the door is open for 1.6000. As stated previously, we would use that weakness again to establish a long CAD short USD position. Main support remains 1.5480.

AUD/USD: It looks like that the Aussie has a lot of difficulty in sustaining levels above 0.5500. Consolidation in a 0.5350 to 0.5550 range may be expected until further notice.