Inflation ahead as economy recovers

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Last year was easier than most for investors. As long as they bought during the lows of the first quarter, almost anything they purchased had risen by the end of December. So far, fund managers have vindicated their assessment that the market lows in March represented a once-in-a-generation opportunity.

But investment strategists have concluded the way forward is less ­obvious. The reason is inflation. A combination of deflation, low interest rates and low valuations in all asset classes presented outstanding opportunities in 2009.

In particular, as inflation had not devalued interest payments in real terms, fixed income looked remarkably attractive. Investors could buy corporate bonds at low prices, and many paid out a disproportionately large income compared with their face value. They also yielded an attractive income compared with returns on cash.

The causes of deflation were relatively simple. The recession had dented demand for goods and services, thereby lowering their price. Deflation, the argument went, could also remain a powerful force if governments unwound the enormous spending used to help the economy out of recession. Jobs would be lost, the money supply would be cut and recession could loom again.

This picture has now been blurred. The economic recovery, unless it is stillborn, should cause inflation – the more money that flows into an economy, the more likely it is to inflate its spending. Also, governments have printed trillions of dollars to pay off their debt bills and those of financial institutions. These trillions should increase the money available to buy goods and ser­vices, which ought to inflate their price.

As these explanations show, the influ­ence of these forces hangs on the whims of the authorities. Peter Lucas, investment strategist at RBC Wealth Management, and Ben Funnell, asset manager at hedge fund manager GLG Partners, have joined a growing chorus that suggests authorities – especially the US Federal Reserve – will do anything to prevent deflation, making high inflation a more likely long-term outcome.

Even if the authorities want to pull printed money out of the financial system, Funnell foresees difficulty in them ­doing so, due to the complex means by which it was injected. In the US, this has included buying asset-backed securities, which would be hard to sell if the process needed to be reversed.

“It will be difficult to take that money out of the system unless you see a huge increase in short-term interest rates, which there is not the political will to do,” he says.

Lucas says some trade rules will have to ­remain stable if the inflation problem is not to worsen. If China let the renminbi increase naturally in value against the dollar, the renminbi’s ­buying power would inflate global prices for raw materials. But if the world moved in a more protectionist direction, the supply of raw materials would shrink, increasing their ­rarity value and cost.

Outcomes like these spell disaster for inves­tors’ current asset allocations, now weighted heavily to fixed income. If inflation accelerates, Funnell says, “fixed income will get hosed”.

Funnell and Lucas conclude investors should buy “real assets” – a diversified range of commodities, collectable items and real estate, to which Lucas adds commodity-related currencies.

Assets with inflation-linked ­interest payments, such as index-linked government bonds, should perform well, as should floating-rate notes. In the case of real estate, rents can be negotiated upwards to reflect inflation, although Lucas warns commercial property, in particular, is “relatively ­illiquid and sensitive to the health of the economy”.

Their views on stocks, however, are more mixed. Lucas says: ­“Although company profits tend to rise with consumer prices, when inflation ­accelerates, investors are less willing to pay up for those earnings.” Funnell says financials “do absolutely horribly”, while companies outperform if they sell commodities or anything that can be repriced in line with inflation. Among the higher-income sectors, regulated utilities make an inflation-linked return and can be expected to pay out a good portion of it to investors.

Lucas warns this investment ­approach will not remain fashionable forever. But, then again, high inflation hopefully will not either.

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