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Investor 500 2011 (Intro): Dealing with inflation

A shaky economy, roller-coastering markets, conflicting forecasts—it’s confusing out there for retail investors. We give you the tools for making sense of the chaos—starting with advice on investing in inflationary times.

(Photo: Carlos Davil/Getty)

Coming out of the 2008–09 market crash, two opposing camps dominated investing prognosis. One feared deflation—the likelihood that continued economic weakness, possibly a double-dip recession, would lead to a downward spiral in prices and asset values akin to Japan’s slow-motion crash of the 1990s. The other fretted about inflation, as governments around the world printed money with abandon and opened the door for real assets to appreciate when measured in that rising money supply. The former advocated investing in cash and bonds, which they felt would at least not plunge in value and possibly end up with higher purchasing power. The latter put their faith in commodities, precious metals and shares of agricultural and resource companies, hoping to match and, with luck, exceed the gains in the cost of living.

Now, in the spring of 2011, it appears we have a winner. Despite lingering weakness in the U.S. economy and the risk of sovereign defaults in Europe, inflation has taken hold. Not at 1980s rates, certainly, but it’s inescapable at the gas pump and the grocery store. Canada’s consumer price index jumped 3.3% on an annualized basis in March.

The inflationists maintain this ramp-up is just getting started. They point to Standard & Poor’s recent downgrade of the U.S. government debt outlook to Negative, suggesting Washington can’t repay bondholders without printing still more money, ultimately driving up prices and interest rates. Pacific Investment Management chief investment officer Bill Gross, who runs one of the world’s largest bond portfolios, has gone from owning tens of billions in U.S. Treasury bills to shorting them in expectation of a dollar devaluation.

If Gross and his ilk are right, that has serious implications for ordinary investors who have gone two decades now without having to give much thought to the spectre of rising prices eating up their returns. If you’re planning on retiring within the next 15 years and, as life-cycle investing formulas recommend, have most of your portfolio in fixed-income instruments, you’ll want to sit up and take notice.

Fund manager Phillips, Hager & North published a note to clients recently on inflation risks, which it sees as likely to build over the next five to 10 years. It observed how the jump in Canadian inflation from 2.6% annually in the 1960s to 7.6% in the 1970s lowered real bond returns on average by 1.6% a year—big money when compounded over a decade. The company then analyzed two strategies for fixed-income investors: short-term bonds that reflect current interest rates, and so-called real return bonds whose interest rates float. “Under most of our scenarios, RRBs have a higher return than short-term nominal bonds,” the report concluded.

Unfortunately, both types of bonds perform poorly compared to long bonds in the modest (sub 3%) inflation environment that we’ve grown used to. That’s led other institutional investors to shift money out of the bond market entirely. Upon announcing its takeover of forest owner TimberWest Forest Corp. for $1.03 billion in April, B.C. Investment Management Corp. and the Public Sector Pension Investment Board explained that “timber and real estate exhibit inflation-hedging characteristics and provide stable risk-adjusted returns.” In other words, they expect income-generating real assets (in this case, land with trees) to hold their value when dollar-denominated bonds do not.

The difficulty with investing in classic inflation hedges such as energy, materials, land and precious metals today is that these sectors have already seen a long run-up and are now fully priced for any kind of growth scenario. Signature Global Advisors senior vice-president Eric Bushell recommends buying stocks in these sectors on the dips, when temporary shocks such as default fears or the earthquake in Japan threaten the global growth trajectory. “Timing can be quite important,” he says.

One of the areas he particularly likes, though it’s highly volatile, is the mining equipment and energy services sector—companies like Schlumberger, Halliburton, Weir Group and Joy Global—in addition to engineering firms such as Foster Wheeler, Parker Hannifin and SNC-Lavalin. These, he expects, will benefit from “the biggest investment boom in the energy sector in the history of the planet.” An opportunity more suitable for reallocating fixed income lies in Australian real estate investment trusts and toll roads, which have good yields and are backed by real assets, he says, but are currently out of favour with investors Down Under.

“How the whole inflationary story unfolds is still not totally clear,” Bushell cautions. He thinks inflation fears will dominate in the short term, but abate as commodity prices themselves place limits on global economic growth.

Others think it will happen the other way around, with inflation a phantom for now but materializing in the medium term. Darren Lekkerkerker, portfolio manager with Fidelity Investments, believes slack labour markets in North America will prevent inflation from spreading beyond food and energy over the next two years. After that, the effects of loose monetary policy will kick in. Nonetheless, he already owns some hedges, such as Silver Wheaton, which (uniquely among miners) is shielded from capital and operating cost increases by its royalty structure, and Suncor Energy, which has the oil reserves to boost production for years to come.

Non-commodity companies that could surprise on the upside include grocery chains, which recently demonstrated their ability to pass on price increases to customers, Lekkerkerker says. Stocks to avoid in an inflationary environment are utilities, telecoms and financials that have less leeway to respond quickly to their own rising costs.

While it’s impossible to foresee the future, you can observe the actions of the people running the present and what they learned from the past. U.S. Federal Reserve chairman Ben Bernanke wrote his doctoral thesis on the Great Depression, a time of paralyzing deflation, Lekkerkerker notes. If he’s going to err, it will be on the side of allowing inflation to take hold.