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Investing in an Inflationary World

by Ram Balakrishnan
September 1, 2008
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Many investors, noting the effect on their wallets while shopping at the grocery store or filling up at the gas station, are worried about an increase in inflation — total CPI, which includes volatile items like food and energy is running at 3.4% and the “core” rate at 1.5%. But, you wouldn’t know it by looking at the bond market: 10-year Canada bonds are yielding 3.51% and are trading close to their 52-week highs. The difference between the yields on real-return bonds (1.55%) and long-term bonds (4.0%) suggests that the markets are guessing that inflation in the future will be a rather modest 2.5%. Nevertheless, here’s how various asset classes have behaved in an inflationary environment:

  • Bonds: Estimating the effect of rising inflation on bonds is easy — it’s bad. And history bears this out. In the 1960s, inflation in Canada averaged 2.6% but spiked in the 1970s to 7.6%. Real returns on bonds fell an average of 1.6% during that decade. It is the direction of inflation that matters, not its absolute level. In the 1980s, inflation averaged 6.2% (lower than the previous decade) and the real return on bonds averaged 6.4%.
  • Real-Return Bonds: Inflation-protection is the raison d’etre of real-return bonds as both the coupon and principal are adjusted for inflation. As already noted, befitting their low-risk nature, the current yield on these bonds is quite low.
  • Real Estate: In Unconventional Success, David Swensen points out that real estate has a high correlation with inflation due to the ability of landlords to increase rents and increase in asset values to reflect higher replacement costs. However, this is only true when valuations are not extreme. Assuming that valuations are “normal” most of the time, REITs perform well as an inflation hedge.
  • Gold: Any discussion of inflation will invariably turn to gold. There are two views on investing in gold. Some, like Benjamin Graham, opine that the US Government did investors a favour when it disallowed its citizens to own gold. Others, like William Bernstein, point out that a small allocation to precious metal equities and diligent rebalancing will help in periods where inflation is soaring.
  • Stocks: Increasing inflation has a negative effect on stocks in the short run as future earnings are discounted at a higher rate and reflected in lower prices. But, in the longer term, at least in theory, businesses will find a way to pass along increasing costs to customers, which will find its way to the bottom line as an increase in earnings. In his commentary in The Intelligent Investor, Jason Zweig notes that out of 64 five-year periods since 1926, stocks have outpaced inflation 78% of the time. During the 1970s, the real return on Canadian equities was 2.4% (-0.7% in the US). Stocks do live up to their reputation of inflation hedges over the long-term but over the short term, all bets are off.

Bottomline: Rising inflation is bad for bonds but stocks, precious metals and real estate are reasonable but not perfect hedges. The only perfect inflation hedge is a real-return bond but their yields are very low.

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