How to protect yourself from infaltion

Should you worry about inflation?

Singapore's annual inflation rate has averaged 3.25 per cent since the beginning of 2009 when the United States Federal Reserve began its monetary policy experiment. The massive surge in inflation feared when the Fed first began its money printing exercise has failed to materialise thus far, especially in the US. Should investors still be concerned about the risk of higher inflation in the future?

In our view, the lack of an inflation surge does not preclude the need for investors to consider the risk of at least moderately high inflation. Near-zero deposit yields mean that the purchasing power of cash holdings would have been eroded quite rapidly even at the inflation levels witnessed over the past four years in Singapore, and elsewhere. Even if cash yields eventually begin to rise, there is no reason inflation cannot accelerate. In our view, investors are likely to be better off holding a diversified investment portfolio which includes some inflation hedges, as opposed to holding cash alone.

What can you do about it?

There are a number of asset classes that offer inflation-hedging characteristics. However, not all of them are likely to be as effective in protecting investors today as they have been at various points in the past.

Gold - the traditional inflation hedge

In our view, however, this may end up being a very ineffective inflation hedge when purchased at current prices. Adjusting for inflation, the "real" price of gold is still not very far from historical highs, even after gold's recent (and significant) price correction. The last time gold was at similar levels (the late 1970s), US inflation was at double-digit levels. Arguably, therefore, gold is already pricing in a high inflation outcome; buying the metal at current prices, therefore, may not help an investor hedge against moderately higher inflation.

We hold an Underweight view on gold and believe the precious metal is likely to weaken further.

Physical real estate - a perennial favourite

There is some evidence to suggest physical real estate can provide a hedge against inflation over long periods of time. However, as with gold, if real estate prices are already well above the long-term inflation trend, the effectiveness of this asset class as an inflation hedge can be eroded. Physical real estate in many US cities, for example, may provide a good inflation hedge as price trends remain well below those of inflation. Physical real estate in Singapore or Hong Kong, in contrast, are arguably now well above long-term inflation trends.

Inflation-protected bonds - a great hedge, but only under very specific conditions

When purchased at issuance and held to maturity, inflation-protected bonds can provide almost the perfect hedge against inflation, as measured by the CPI index. However, when either of these conditions does not hold, the picture is far from clear. Purchasing inflation-protected bonds in the secondary market, for example, brings us back to the point that it can act as a good inflation hedge only if it is not already pricing in a high level of inflation. In the US, Treasury Inflation Protected Bonds (TIPS) are already pricing in a moderately high level of inflation; therefore, once again we do not see them as a good hedge against inflation at current levels, unless inflation accelerates significantly.

Equities - particularly those with some pricing power

This remains our preferred asset class. Evidence suggests equities can provide an effective hedge against moderately high levels of inflation. Intuitively, this makes sense - a listed company will usually own assets that rise in value with inflation, and most firms have some degree of pricing power to preserve the real value of their earnings, which should ultimately get reflected in the value of a stock.

Perhaps most importantly, we believe equities (particularly those in developed markets) are currently inexpensive on a number of measures of value. While this raises a number of other factors favouring equities, this suggests that this asset class may provide a good alternative to investors looking to own some protection against moderate higher inflation.

How do these fit into an investment portfolio?

Financial markets are, by nature, uncertain. A diversified portfolio is almost always a good starting point to ensure investors are not caught out by potential surprises - an unexpected jump in inflation being a great example. As described above, we believe a portfolio that is Overweight equities is likely to offer the best risk-return trade-off and hedge against moderately high inflation at this time. The fact that we like the equity asset class for many other reasons over and above inflation-hedging makes the case for equities even stronger, in our view. We would be extremely cautious about blindly jumping into traditional inflation hedges like gold because we believe current, elevated price levels do not really offer investors much room to hedge against moderately higher inflation.

Source: 30th August 2013 Business Times

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