Threats from inflation lie in wait over the horizon

The outlook for inflation is a key variable in the investment decision-making process for private bankers. They need to manage wealthy clients’ portfolios to ensure real purchasing power of capital is maintained, in order to meet living and business expenses and other liabilities.

But views on the growth rate of prices are far from certain this year, according to Steve Brice, chief investment strategist at Standard Chartered in Singapore.

High debt levels in developed markets raise the risk of a sharp deleveraging process, which could be deflationary as growth slumps and unemployment rises, but they also increase the incentive for policy makers to inflate.

“Policy makers will be very keen to avoid a situation where any public or private sector austerity turns into a destructive debt deleveraging cycle,” states Mr Brice. “This leaves a combination of inflation and modest austerity measures as the most likely outcome.”

In this environment, being overweight gold and gold equities “help mitigate the potentially deleterious effects of inflation on investment portfolios”.

However, the consensus is that inflation will not be as severe as it was in 2011. On the contrary, it is expected to fall.

Last year, all countries were significantly affected by the significant rise in commodity prices resulting from strong demand in emerging economies like China, India and Latin America. Also, a strong recovery in parts of the global economy in 2009-2010 carried through into commodity markets.

The weight of food, energy and other commodity related prices in the headline consumer price index is quite high, and it varies from 30 to 45 per cent in some emerging countries to 15 to 30 per cent in developed economies, explains John Greenwood, chief economist at Invesco. There are also some indirect effects, as oil price feeds for example through a whole range of other services, like transportation and heating.

But renewed recession in the eurozone, along with slowing growth in emerging markets, is likely to abate demand for commodities. “In order to have a meaningful impact in raising the CPI, commodity, energy and food prices would have to rise again in 2012, above their 2011 levels, which is very unlikely, given the state of weakening global demand,” he says.

Moreover, the enormous amount of liquidity that the Federal and European Central Banks have been pumping into the system, which in normal conditions would drive prices up, is not feeding inflation, despite widespread fears. Economies in the US, UK and the eurozone are overleveraged, which was one of the reasons that led to the crisis. Today they have to deleverage and reduce their debt burden, be it households, corporations or governments.

GOING BACKWARDS

“Generally speaking, in a deleveraging environment, the risk is more about deflation than inflation,” says Alexander Godwin, global head of asset allocation at Citi Private Bank. Banks are required to raise capital ratios and choose to do that by reducing their balance sheets. This reduces the amount of loans they make, which is another deflationary force.

Despite the huge amount of stimulus injected into economies, the velocity of money is low, and its multiplier effect is falling. “In most of the Western world right now, the private sector debt as a proportion of the GDP is too high and, until that comes down, the demand for credit will be low, which will severely dampen the effects and the effectiveness of monetary policy,” says Mr Godwin.

Emerging markets, on the other hand, have been tightening their monetary policies and many are in a position to cut rates again, as inflationary expectations are falling or slowing down in China, Brazil, Indonesia and India.

The biggest upside risk to inflation in the short term is probably geo-political risk, says Mr Godwin. “Political instability from Iran or other oil producing nations could cause a very dramatic spike in oil price which might lead to some short-term inflation effects.”

But should wealth managers and investors worry about inflation only when it is a threat in the short term? And how should this outlook affect asset allocation strategies?

INEVITABLE POLICIES

Given the state of government budget balance sheets, it is inevitable that in the UK, the US and probably Europe, governments will pursue inflationary policies over the medium term, states Robert Farago, head of asset allocation at Schroders Private Banking. “It is difficult to predict when, but at some point over the next decade, inflation will kick up quite substantially. We see inflation as a longer-term problem and we are really looking for investments that can protect against long-term inflation but also make sense on a one to three-year horizon.”

At the UK bank, in addition to gold and gold equities, hedges against inflation include inflation-linked bonds, mainly UK government index-linked bonds and US Treasury inflation protected securities.

For the 10-year US bond the break-even inflation rate is 2 per cent, he explains. This is the level above which investors would be better off in buying index-linked bonds, and below which they should favour nominal bonds. “US inflation is expected to fall below 2 per cent in 2012 and may well stay there in 2013. But, on a 10 year view, we would be fairly confident it will average more than 2 per cent. When inflation picks up, there will be no real incentive to tackle it, because inflation can bring down the level of debt relative to GDP.”

In the UK, the break even inflation rate is 2.7 per cent. This is below the 10-year average inflation of 3.1 and the 3.9 per cent average of the last thirty years, which still misses out the 1970s when inflation hit 27 per cent. Although it will come down over the next two years, inflation will be above the 3.1 per cent average on a 10 year view, he predicts.

If gold and inflation-linked bonds are the obvious places to park your money if you are worried about inflation over the long term, systematic trend followers offer a more unusual way of getting inflation protection, believes Mr Farago. “We invest in CTAs as a portfolio diversifier, as a strategy that typically benefits from the rise in volatility, which is often when other assets decrease. But over the long term, we see them as one of the few strategies that could benefit from an inflationary environment.”

It is important to keep in mind that protection against inflation must be a long-term approach. “Inflation should always be a factor in portfolio construction with the focus on hedging long-term inflation trends rather than short-term movements,” says Citi’s Mr Godwin.

Investors must keep up with high or accelerating inflation by owning assets whose revenues rise by the rate of inflation over the longer term, such as property or equities, but invest in them only when valuations are attractive.

On the equity side, favoured companies are those with high quality management, safe balance sheets and which generate high dividend yields in areas such as utilities, pharmaceuticals and telecoms. From a regional perspective, Citi’s focus is on European equities. The worst case scenario in Europe, such as a break-up or default, will have a similarly negative effect on both US and European stocks, explains Mr Godwin. “The difference is that valuation levels of European equities are extremely low, in some cases half the valuation levels of the US, as they already factor in some of these potential problems, whereas the US stocks do not.”

Corporate bonds, and particularly high quality corporate bonds in the US, are still attractive, as their yield levels are high and spreads against their government bonds are wide. “The corporate sector is currently focused on maintaining very strong balance sheets, on raising their credit ratings and paying down debt, so this is one of the key areas within fixed income people should focus on.”

THE LURE OF GOLD

At Lombard Odier, wealthy clients are recommended to invest around 10 per cent of their assets in gold, mainly gold bars but also physically-backed exchange traded products. “Gold is not a hedge against inflation,” states Sébastien Gyger, head of portfolio management for private clients at the Swiss private bank, “but is much more interesting in a deflationary type of environment, as a hedge against the systemic problems in the monetary and banking systems, such as we have today.”

Low inflation, low inflation expectations and improving economic background are supportive of equity, he says. “Because of decreasing inflation and policy easing, the economic background is improving and cyclically it is more supportive of equities.”

Europe is the largest overweight in equity portfolios, but the bank’s focus is shifting from very defensive to more cyclical firms. “We see value in companies with good balance sheets in the energy and material sectors. These have been punished by the market, which was solely interested in defensive names, but we found very good entry points there.”

In the UK, the average inflation rate last year was much higher than the eurozone’s and protecting portfolios against rising prices has been a core topic in conversations with clients of late, says Oliver Gregson, head of sales, marketing and product development at Barclays Wealth. The aim is always to deliver inflation-proofed, net of tax, positive returns, but today the need to hedge portfolios against rising prices is not as high as it has been, he says, as inflation globally will slow and pick up towards 2013-2014.

A combination of different instruments – such as index-linked bonds, commodities, commercial real estate and equities – needs to be used to build protection against inflation. “No one instrument in the whole is the perfect solution, as there are no perfect hedges against inflation,” he says.

Commodities do not provide a consistent hedge to inflation as correlation of commodities as a whole asset class to inflation is not stable, says Mr Gregson. Gold has not been a reliable inflation hedge, either, he argues. Its performance is uncorrelated to inflation over time and is being greatly influenced at the moment by speculative flows, by the size of investments for example into exchange traded products.

In the equity space, firms that are good hedges against inflation are those that have pricing power and are able to pass on pricing increases, such as well established brand names, where consumer demand is less sensitive to price, or regulated utilities, whose rates are often linked to inflation.

But allocation to those types of instruments has been reduced of late. “The US is probably one of our highest convictions for 2012,” says Mr Gregson. They will continue to deliver solid economic growth, the consumers’ area is in better health than many realise, and there are some attractive investment opportunities. “We are still seeing substantial earnings growth from US companies, despite a lower level of economic growth.”

Although Europe ex UK represents the second most attractive market, because of low valuations, only a resolution to some of the issues Europe is facing will see those valuations realised, he says. Allocation to emerging market equities has been lately increased by two percentage points, to 10 per cent of total assets in an average portfolio.

“Emerging market stocks, while relatively high risk, will deliver probably the best excess returns on average over the next five years plus,” states Mr Gregson.