Outrunning the Inflation Genie
16 June 2010Here’s one for readers of economic history: Of these, which decade witnessed the biggest stock-market decline – 1930s; 1970s; or 1980s?
It would have to be the 1930s, of course, in the midst of the Great Depression; or could it have been the 1980s, with the calamitous sharemarket crash of 1987?
Sorry, wrong on both counts. It was the 1970s, because of the corrosive affect that rampant inflation had on share price values.
The 1970s coupled a bear market with inflation, with the net result that in the US, the S&P 500 lost 1.4% after inflation during that decade. Even the 1930s decade ended in positive territory.
There is concern in the markets about the return of high inflation rates after a decade where most central banks thought they had that genie firmly corked. But now, post-GFC, economist and investors are pondering the effect of billions of dollars worldwide being pumped into the system by various Government fiscal stimulus packages, coupled with the loosening of monetary policy from respected bodies such as the Reserve Bank of Australia.
For the modern investor, getting a handle on which investments might be prone to the ravages of inflation is a tad slippery. Diversified investors hold many types of assets – some more sensitive to inflation over the short term, will others more vulnerable over the long term.
As far as outlooks go, both time horizons should be considered when choosing the type of investment and its susceptibility to inflation.
In my view, inflation is likely to be tame in the short run (next three years), but those with a five-year or greater investment horizon the threat of inflation should well and truly on their radar.
Whatever the case, investors should educate themselves about inflation and the measures they can take to counter its caustic affect on value.
Commodity investment is a traditional choice as a hedge against inflation – other than direct investment in gold and other commodities, this can be achieved through specialised funds and customised investments..
The logic seems to be that as demand for goods and services increases, so the price of goods and services rise also, as does the price of the commodities used to produce those goods and services.
Of the commodities, gold stacks up as the historical hedge against inflation. It shows a 60% correlation with inflation, revealing why it is a popular choice as a destination when there is a flight to safety. Oil, however, has only displayed a 21% correlation to inflation.
Despite the historic coupling of commodities and inflation, figures show that commodities still tend to underperform inflation.
Rather than take a safe haven approach by storing wealth in gold and silver bullion, there is another way of beating inflation - by outrunning it.
This is where emerging markets, or resource stocks, can show their attraction as value bets in high inflationary times.
Typically, developing nations are leading producers of raw materials and commodities, whose prices tend to keep pace with inflation (think Brazil and, Russia,), making emerging market stocks a good inflation hedge. It is also likely that inflationary pressure will be driven from these emerging markets, particularly China and India, which will affect the value of these share markets.
Also, these markets can also provide diversification in the event of deflation in major developed economies. Fast-growing China and India are likely to keep expanding – on rising domestic demand alone – even if the rest of the world lags behind. The Chinese economy, if any one needed reminding, is forecast to grow about 8% or more every year for the next decade.
One needs to be quick, however. The cost of investing in high-returning emerging markets is increasing. Only last month, Swiss investors ploughed two billion Swiss francs into emerging market bonds and one billion Swiss francs into emerging market equities.
An alternative strategy that might appeal to more conservative investors is Australian resource companies. Their valuations will be affected by many of the same factors that influence emerging markets – although not entirely. Local factors still come into play, of which the Labor Government’s proposed resources super profits tax is the most obvious example.
Emerging markets offer a growth opportunity, as well as helping protect a portfolio from long-term inflationary expectations. That said these markets are still not for the faint-hearted; they have their own issues such as settlements, currency movements, and tax. The need to do your homework remains paramount.
By Justin Byrne
