KEY POINTS:
Two weeks ago we looked at the imminent threat to investment portfolios posed by inflation. Tim Bond, head of global asset allocation at investment bank Barclay's Capital, in London, argues "inflation is now the dominant global economic risk. With one or two honorable exceptions, policymakers have not, so far, moved to actively combat inflation.
"Not since the start of the 1980s have signs of rising inflation been so ubiquitous or so intense. For the foreseeable future, inflation is likely to be the dominant fundamental determinant for asset returns."
That certainly doesn't sound good. But, fortunately, in a later report Bond proposes a number of strategies for institutional investors/hedge funds to beat inflation. Some of these involve complex derivative-based strategies where the investor sells (shorts) one index and buys another.
Understanding this sort of trade, let alone implementing it, is difficult for most retail investors. But variations on the remaining strategies could potentially be employed by Mum and Dad in Tauranga directly and, of course, the hedging strategies are precisely the sort of thing one employs a fund manager to do on one's behalf. Absolute return managers who focus on achieving a positive result in all market conditions apparently make lots of use of this type of shorting technique.
High or rising inflation has a long history as a notorious destroyer of the value of financial assets. As noted two weeks ago New Zealand has a particularly bad inflation record which, when combined with interest rates less than inflation, saw many people's spending power quickly disappear.
Bond says inflation causes the real value of income streams to decline and macroeconomic volatility to rise. Investors react to the loss of real income by demanding higher interest rates on bonds and to the rise in economic volatility by pushing share prices lower.
So the first and most obvious way of profiting from inflation is by "shorting" bonds and shares. Shorting usually involves selling a share or block of shares via a share index before one owns it with a view to buying it back at a lower price to "cover the short".
Kerr Neilson, of fund manager Platinum Management, became a legend overnight during the 1987 crash as he had a major short position on the S+P500 index and, when it fell, the gains he made by buying it back at a lower price offset much of the losses on the fund's share portfolio.
There are two big drawbacks with shorting. Firstly, your losses if you get it wrong are potentially unlimited, whereas when you own something you can only lose what you paid. Secondly, the stockmarket goes up a lot more than down so in the long run shorting is not a bright move.
Most retail advisers would not advocate shorting strategies so this is a good idea from Bond but not practical for Mum and Dad.
Bond then notes that bonds underperform shares in inflationary periods, so to make money from this investors could short a bond index and buy a share index. Again this advice doesn't have much relevance for the do-it-yourself investor but it is good background for people who invest in an absolute return manager or hedge fund as these are typical strategies.
Bond's third point, however, is a particularly good one and it is simply the observation that the stockmarket falls and interest rates rise with high inflation, which makes them both good buying at that point, especially when inflation eventually falls again and bond prices and share prices rise.
Bond illustrates this point by a graph showing rolling 15-year returns following periods of high inflation are high for both bonds and shares. Bond notes short-term share and bond returns are negatively correlated with inflation but long-term returns are positively correlated with the rate of inflation at the start of the holding period.
So we know that high inflation interludes are buying opportunities for stocks and bonds. But the big question is, "Is inflation high now?" We know it's worse than it was but the historic data tells us to hold off buying until it reaches its high point, and it's not obvious that we are at that point yet.
Bond notes the only free lunch in investing, diversification, doesn't work in inflationary periods. When inflation is high "diversification is just a slower way of losing money than handing it out on a street corner".
The table on the right illustrates real returns for the US and UK in the "great inflation" period of December 1969 to December 1980. Then, as now, energy was the big winner, hence Bond's advice "the fourth way to profit from inflation is to avoid diversification and focus investment on the handful of assets that benefit from inflation. This suggests a focus on the resources causing inflation - reinforcing the case for the inclusion of physical commodities in portfolio allocations."
A fifth way to profit is inflation-indexed bonds. In New Zealand the Government has issued inflation-indexed bonds which pay a set interest rate plus index the value of the bonds to inflation.
Bond's sixth and final inflation hedge is that old favourite of the doomsters - gold. The barbarous relic returned 842 per cent after inflation in the 1970s, but from 1980 to 1982 gold prices halved. Gold is extremely volatile, thus should only have a small role in inflation-hedging portfolios.
Bond concludes a portfolio adopting all of the above would look rather exotic. The advice is for institutional investors at the margin - a hedge fund that followed the advice might switch 1 per cent of its equity portfolio to gold or increase the weighting in energy stocks by 1 to 2 per cent.
Lastly, investors should note that by the time they read about the "threat of inflation", its effect may well already be factored into prices and there is no guarantee history will repeat. Individuals contemplating their own portfolios should get expert advice.
Brent Sheather is an Auckland stockbroker/financial adviser and his free adviser/disclosure statement is available on request.
