By Jeremy Gaunt, European Investment Correspondent
LONDON (Reuters) - The specter of inflation has risen over financial markets and is likely to haunt trading in stocks, bonds and currencies this week with oil at record highs and central banks balancing price fears with economic weakness.
Current thinking among monetary officials will be on display and keenly watched with minutes of last meetings being released from the U.S. Federal Reserve, Bank of England, Bank of Japan and Reserve Bank of Australia.
The issue for the central bankers -- and, by extrapolation, for markets -- is how moves to lower interest rates to stimulate ailing economies can be sustained at a time when prices are rising globally.
"Inflation is too high in the U.S., in the UK, in the euro area and in various emerging economies," said Lex Hoogduin, chief economist at Dutch investor Robeco Group.
"The risk (is) that wages will start to increase. At the moment we are on a knife edge."
Hints from the central banks that they are becoming more worried about inflation are likely to impact assets in different ways.
Currencies are sensitive to individual countries' interest rate prospects. The dollar, for example, has been rising lately as investors have begun to scent that the Fed's rate cutting cycle may be nearing a pause.
Inflation concerns, meanwhile, have already hit bonds and could do so again this week. Yields remain relatively low given the backdrop of economic concern. Inflation would be expected to change this.
Quentin Fitzsimmons, head of government bonds at British fund firm Threadneedle, said as much last week.
"There is a chance that markets are being complacent about inflation," he said in a note.
As for equities -- which are seeing large inflows of cash and, on a global basis, have almost climbed back to wipe out all of this year's losses -- inflation is a mixed bag.
Over the long run, rising costs undermine corporate earnings. Short-term, however, demand for stocks can rise primarily because bonds and the like become less attractive.
GUSHING OIL
Although inflation is showing itself in plenty of places, the headline grabber has been and will likely continue to be the price of oil.
New York crude (CLc1) stormed to an all-time high above $127 a barrel last week and few analysts are expecting an immediate respite from record-breaking rises.
U.S. investment bank Goldman Sachs, for example, has lifted its second-half 2008 forecast to $141 a barrel, while its Swiss rival UBS told clients to expect a triple-figure oil price through at least 2012.
For this week, there are no major scheduled supply events -- that is, data or meetings that would change views on the availability of oil. But almost any surprise could send the price higher.
Indeed, some investors have already begun changing their portfolios to reflect a new world with sky-high oil costs -- a factor that could begin to impact markets this week.
UBS, for example, said on Friday that was raising its recommended allocation to inflation-linked securities, those whose returns are tied to the inflation rate.
The UK investor Threadneedle, meanwhile, not only warned about government bonds. It recommended tapping into the massive transfer of wealth from oil importing nations to oil-producing ones, where consumer-related stocks such as retail, property and mobile telecoms could star.
Among the bluntest assessments so far, however, has come from Tim Bond, head of asset allocation at Barclays Capital.
"Investors need to be prepared for a very unpleasant few years," he said in a note. "Portfolios need to be narrowly focused on the handful of assets that cause -- or benefit from -- inflation.
"Bonds of all types -- aside from index-linked -- have no place in portfolios at current yields. Equity exposure should be narrowed to energy, basic resources, industrial goods and services and -- once the write-offs are complete -- financials."
DATA AND EARNINGS
As well as this new wall of worry, market will also be eyeing a stream of economic and corporate earnings data to see to what extent a global economic slowdown is taking hold.
Among major economic reports are U.S. wholesale inflation data on Tuesday and Germany's Ifo business sentiment index on Wednesday.
Most major U.S. companies have already reported their latest earnings but Europe still has some way to go. Among the names issuing updates are Imperial Tobacco (IMT.L), Marks & Spencer (MKS.L), Bank of Ireland (BKIR.I), EMI (EMI.EU) and Air France-KLM (AIRF.PA).
Inflation is not far away, however.
Investment bank Citi noted last week that so far the number of companies beating estimates is very slightly higher than those disappointing.
The oil and gas sector, it said, was one of the only ones to have seen an upgrading of earnings per share estimates for the future as a result of its most recent performances.
