The Great Inflation of 2012
The Great Inflation of 2012
Despite being born in the same decade as the rest of our analytical team, I’m known around the office as something of a cantankerous old bastard.
Harsh, I’d say. But if thinking that people should accept some responsibility for their own actions means you’re cantankerous, then I’m guilty. The solution to our financial predicament seems to be to rescue everyone who’s been spending more than they earn and living in houses they can’t afford, by printing as much money as we can and deflating the wealth of those who actually had the temerity to save (yes, that includes me). Apologies, but it riles me.
And it’s also causing me troubles from an investing perspective. As they attempt to save the world, central bank printing presses are running red hot. As well as degrading their currencies and balance sheets, I expect the logical outcome of all the hyperactivity will be inflation. It will return, and perhaps quite shockingly.
Renowned investors
And I’m not on my own. Quite a few renowned contrarian investors (many of whom foresaw the financial meltdown of 2008) are now concerned about inflation.
Warren Buffett, in an op-ed piece in The New York Times last October, said that the ‘policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts’.
Seth Klarman, a value investor with a very impressive long-term track record, is similarly concerned. In his quarterly letter to investors in October last year, Klarman wrote: ‘The extraordinary and unpaid-for financial market bailout should add to inflationary pressures over time, especially when the economy begins to recover from the current economic downturn. Against this possibility, Baupost has built a sizable position in low-cost inflation protection for the next three to five years.’ Elsewhere, he said: ‘We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge.’
Dr Doom
The original Dr Doom, Marc Faber, has been calling for the collapse of western capitalism for some years. Finally, the world is listening. More recently, in this Barron’s article, he called the US treasury market the ‘short of the century’ as a result of his inflationary views. Similarly prescient newsletter writer Jim Grant, of Grant’s Interest Rate Observer, sees the US working towards disastrous inflation and has referred to US government bonds as ‘toxic treasuries’. He’s also expecting a significant rebound in commodity prices down the track.
Of course, not everyone thinks inflation will be a problem soon. Jeremy Grantham, who warned us all about the bubble years before it burst, suggests inflation could be an issue down the track: ‘Don’t worry at all about inflation. We can all save up our worries there for a couple of years from now and then really worry!’ Of course, just because inflation might not show up for a while doesn’t mean one should wait before taking out insurance.
The good news is that with most investors panicking about deflation and recession, today’s market is offering cheap long-term inflation bets precisely because the majority of investors are looking the other way. Now’s the time to start thinking about how to protect yourself against inflation, and even set up to profit from it.
Finding good hedges can be tricky, though. You can short US treasuries via short exchange traded funds as recommended by Marc Faber, such as the Pro Shares UltraShort 20+ Year Treasury, which make money when US bond yields go up. But this isn’t necessarily a low downside bet, and it introduces currency risk for an Australian investor.
Traditional hedges
Then there are traditional inflation hedges like gold, oil or timber, or a broad commodity exchange traded fund. Property is also known as an inflation hedge, although I’m convinced that Australian residential property has some more deflating to do before it starts inflating again. Perhaps farmland is the way to play it, although farms can also be tremendous capital sinkholes. At the riskier end of the spectrum, options on commodities or shares of commodity producers could be interesting.
Another possible solution is to buy shares in non-capital intensive businesses with significant pricing power. At the least, steer clear of the opposite – capital intensive businesses with limited pricing power are usually hazardous to one’s wealth, but particularly so in an inflationary environment.
Likely, the problem needs to be attacked from numerous angles. I’m still mulling over the issue. Whatever the solution, though, I’m convinced the problem demands attention now, before the rest of the world starts taking inflation seriously. I’m searching for low downside, true inflation hedges. If you know of any, be sure to let me know.
By The Intelligent Investor senior analyst Gareth Brown.
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Comments
Hi Gareth,
Could you give an example of a “non-capital intensive business with significant pricing power” and describe how buying this business would be a hedge against inflation rising? I assume it is because it can adjust its prices with inflation quickly and without losing business…
Thanks in advance,
A mate of mine recently pointed me back to the 1981 Berkshire Hathaway letter to shareholders (unfortunately, their website is currently down) for an excellent piece on the effects of inflation on good and mediocre businesses, using See's Candy as an example. But the short of it is that having pricing power protects your revenue from the ravages of inflation, while being non-capital intensive in nature means you don't have to massively increase your investment in the business as time goes by as a result of inflation. You'd want both attributes to feel safe from rampant inflation.
Cochlear is the best Australian example I can think of, although the price isn't cheap. ASX might be another, although its business faces some new competitive threats. Cabcharge's taxi payments business probably fits the bill, too.
I've also been thinking about good fund managers and the advisory portion of Macquarie Group's business (corporate deals and raisings should reflect the impact of inflation and are usually negotiated as a percentage of the transaction value).
sugar
Thanks Guys
Hi Gareth,
Very important issue you have raised i e inflation in a few years is highly likely.
I have discussed this with a friend who runs a Hedge Fund abroad and he pointed to something like Global Mining Investments ( GMI ) as a no brainer for Aussie retail mum and dad investors. I note GMI ,s last list of holdings seems to suddenly include lots more Gold Miners. Perhaps the managers there are thinking along similar lines.
What do you think ?
Cheers,
Damend
I'd be wary of investing Aussie dollars in US dollar denominated commodities it if is global inflation you are worried about. You might see a surging AUD against the USD wiping out your gains- which might be an inflation hedge its self now I think about it!
What about regulated assets with CPI linked revenue? Inflation will reduce the real value of the debt whilst revenue soars on the other side of the ledger? Although not one for your life savings, I was thinking the BEPPAs would be an option. Inflation would make BBI more solvent making the BEPPAs safer and you get a take (shares) or pay (cash) option in 3 years. Time horizion might not quite be long enough but, ironically, inflation might be what saves a number of these debt securities!
My view is that I agree inflation is coming (down the track) but that investors don't need to start panicking. If you're a property owner, you actually benefit from inflation. Just don't hold too much debt against it, because the higher interest rates that will be necessary will take much more of your cash flow than the interest bill you have now.
Also, while inflation is not generally desirable, shares are the 'least bad' asset class to hold under inflationary conditions. And here, too, you can increase your odds of doing OK. What you don't want to own are asset-heavy, capital intensive businesses. Rather you should prefer service type providers or those that have pricing power (i.e. exactly the sort of businesses that value investors should probably prefer anyway). And cash is always the worst investment class long term, so no surprises there.
Leave the fancy strategies to the pros, I'd suggest, and just try to buy the same quality assets you always did (or should have!).
Have you read 'The Inflation Crisis and How to Resolve It' by Henry Hazlitt? It's available from Mises.org as a .pdf file for download.
I'm not sure I'd want to put much into mining stocks as my hedge against inflation, too risky. But it certainly could be part of the solution - gold stock in particular are likely to prove a leveraged hedge. Then again, the only two gold stocks I've ever bought cost me plenty, so it's not an option I feel particularly comfortable with.
Good point on the currency, that would especially prove a problem if the Aussie dollar is surging against all other currencies, as opposed to US dollar weakness. Presumably, US dollar weakness would see some corresponding increase in US dollar denominated commodity prices.
Regulated assets with CPI-linked revenue could be part of the solution, although most of those possibilities in Australia currently face solvency issues as a result of too much debt. But survivors could pay off very handsomely. I do own a very small amount of BEPPA, and it offers significant upside. But I can also envisage a scenario with raging inflation but no benefit going to BEPPA holders because it's already gone bust (as you've pointed out). Very interesting for a small bet, though.
Not my area of expertise but I believe sugar performed very well during the 70s inflation period. A few potentially major changes since then include the diet-revolution and, in particular, replacement with corn fructose. Also, at some low oil price, Brazilian cars are likely to switch back to gasoline over ethanol, although I don't know at what price. I don't know how that would affect sugar supply or whether Brazilian farmers would simply switch to other crops like soy beans, but an issue to consider.
I took a punt and bought some Newcrest Mining ( my first ever gold stock ) late last year and its already gone up a fair bit, which is not something I can say for any of my other recent buys.
Now I'm thinking , is this a bubble forming in the gold sector ?
Cheers,
Damend
Good article Gareth and I'm in general agreement with the points you raise. From my own personal experience and from speaking with friends, it would seem that a large number of companies have instigated a wage freeze and/or introduced 9 day fortnights etc. Do you feel that this will subdue inflation to an extent (ie people have less to spend on goods) or is this irrelevant when compared to the increased government spending?
Sugar producers do not fall into the “non-capital intensive business with significant pricing power” category mainly because it's a commodity. And by definition the prices of commodity is determined largely by the market. Not to mention it's very capital (and energy) intensive industry with relatively low entry barrier.
Electronic business models that are easily scalable like Seek (SEK) should fall nicely into the category. The chief concern here is the low entry barrier for such businesses.
I'm curious about everyone's opinion on using the ASX quoted ETFS Physical Gold (GOL) as an exposure to physical Gold? I read about their switch from ASX listing rules to ASX AQUA from their 3/2/09 Letter to Shareholders. I'm a bit concerned because under AQUA rules, there is much less transparency in the company's operations. For example, the company is not required to have continuous disclosure and Periodic disclosure to ASX, and there are no requirements for disclosure of "takeover bids, share buy-backs, change of capital, new issues, restricted securities, disclosure of directors' interests and substantial shareholdings".
I understand that this is done as a way of increasing the liquidity of the company and to reduce management expenditure, but would that would make the company much more secretive in its dealings. I would like to hear your thoughts on that.
Great article Gareth - the issue of inflation further down the track has been occupying my thoughts more and more in recent months.
I've been trying to identify opportunities that will provide, as you put it, "low downside, true inflation hedges". At this stage I've been leaning towards investing in(though haven't yet acted) floating rate income securities. With a number of securities already trading below face value, you can expect to pick up some capital gains as they get closer to maturity. And by opting for floating rate securities the yield should pick up as interest rates are increased to bring inflation back down. Permanent loss of capital should be able to be minimised by keeping to well capitalised companies. Whilst short-term capital (market) value would remain relatively stable, unlike fixed rate securities that would come under pressure in a higher interest rate environment.
The difficultity I'm having is finding suitable securities that mature well into the future whilst still providing reasonable returns if high inflation doesn't eventuate.
I'll let you know Gareth, but only after I'm fully set.
This suggested appreciation of AUD against USD assumes that Australia will not suffer the inflationary pressure to anywhere near the same degree that the US might. We have not been effectively printing the multi trillion dollar amounts that the US has, but I am still not sure that we will escape all of the inflationary impact that will result from all of this. We saw Australian inflation rise strongly over the last few years driven significantly via factors such as both soft and hard commodities. Inflation could set all of this up again. Also if the US has very strong inflation, their interest rates will need to go up a long long way to bring it under control. This could cause a second recession, but higher interest rates in the US will also limit AUD gains.
In my search for conflicting evidence, I came across this article on Prem Watsa. He seems to agree with Jeremy Grantham, inflation could be an issue down the track but not today. Again, though, I'll reiterate the difference between the timing of inflation and the right time to search for inflation insurance. Anyhow, some of you might find this article interesting:
http://tinyurl.com/b5nvas
Gareth
Possible options I have been thinking about to counter future inflation problems are:-
1. Indexed Bonds? My limited knowledge is the capital price is indexed to CPI and the investor gets a small interest rate of approx 2-3%. Is there a retail secondary market?
2. Warrants to buy gold? Main negatives are you are exposed to currency fluctuations, no income and is turnover in secondary market reliable?
3. Property - in the 1970s inflation, a lot of fortunes were made buying property with debt and letting inflation pay off the debt. However, the political interest rates meant your mortgage rate was 7% while inflation was 10%. Independent RBA should eliminate this option. Also current property prices are still too high and unemployment risk means avoiding debt.
4. Shares - High yielding shares. Main risk is cuts to dividends and dilution of capital by deeply discounted placements.
5. Corporate Debt - A lot of good corporates are currently paying 8-10% on their debt. I'd love to be able to lend to Wesfarmers at 7%. Even better if I can later convert to equity on favourable terms. Seems to be main option of Buffet at the moment. Current retail bond market seems to be mainly for high risk financials.
Thanks
Geoff
I have been through a number of recessions since I started investing in 64. I am again expecting a period of inflation , possibly starting around 2011.
There are great oppurtunites here provided the companies you select do not go broke before then - obviously.
The big benificiaries of inflation are companies with
1. High Debt levels (preferable long term fixed rates)
2. CPI tied incomes
The obvious choices are LPTs and regulated infrastructure. Their share prices are virtually at writeoff at the moment. However remember the main rule, they have to survive the depression before you (they) can benefit.
I don't know, all this talk about chopping and changing strategies to suit the current or next economic climate... it sounds a bit like the sort of thing we come to expect from mainstream economic commentary. Surely as value investors we view the current value of an investment in terms of its LONG TERM prospects. Doesn't this imply that our investment approach and principles should be essentially constant over the years? No matter what the present circumstances may be, we should always view the future in the full knowledge that it probably holds bouts of inflation, recession, booms etc etc. Whether we are contemplating an investment today, or whether we were 2 years ago during the height of the boom, surely we hope that our investment (or our portfolio) will be resilient to whatever the future may hold. The reason we are attracted to businesses with wide moats, high returns on capital, low debt, rational managers, high integrity etc, is that they generally deliver superior results over the LONG TERM. The reason they do so is that they are more able to survive the ravages of time, and the unpredicatble economic climates that the future will deliver. If we change our strategy to accomodate our outlook for the medium term, do we not run the risk of not being true value investors?
Similar sentiments to JG's, I think, Mars. And, essentially, I agree. Especially as fixed interest investments are rapidly becoming the flavour of the month (year?) for certain mainstream commentators and investors seem to be losing interest in the sharemarket (though we're not quite at the infamous 'Death of equities' stage yet). This is leading to some former darling (and ostensibly quite attractive) businesses being sold down to prices we haven't seen in many years (eg Brambles and Billabong, just to name a couple of 'B's).
Remember oil at $150 a barrel going to go over $200 dollars a barrel peak oil and the china boom was the story.
Remember the china story how was going to decoupled
and save Australian from a recession just good example of two myths.
Now we have the inflation story money printing and we are going to lose all our saving to inflation.
Fact is the world investors have loss over 40 trillion dollars in bad overvalued investments and it is not over yet and on top of this most banks are not lending as much and being very conservative asking at least 30% deposit and looking carefully at real valuations.
No government in the world can replace the amount of wealth loss by investors.
The government will save as from a very bad recession myth will be smashed this year.
To have inflation you need the money to be given to the masses big time causing a boom in all asset classes.
Banks are being very careful and don't want to get their fingers burn again.
So it will be deflation going forward however all bets will be off if the government becomes very stupid.
I would agree with Stephen Johnston. The risk now is deflation. Yes the printing presses are working overtime but the asset destruction has been extreme. The actions of the Fed would also seem to support the view that they are scared of deflation. Not that following the Fed is the answer to all questions but obviously the data they are seeing shows a deflationary picture.
Not yet, but I just downloaded a copy. I have a lot of sympathy for the Austrian school view. Unfortunately, I don't think the powers that be will pay much attention to Hazlitt's suggestions, if history is any guide. But looking forward to reading it.
IF the government becomes very stupid?
Gareth, Absolutely agree with letting the people who got themselves into the s--t get themselves out ---seems all govts. disagree ,left,right or otherwise---have a sneaking feeling that the first countrys govt to commit to letting the markets work without "stimulous packages" will boom --is there one with the courage ? To my thinking the current world response to this crisis is "Lemming like "Tom
Gareth, I have heard a few prominent industry experts (David Morgan, ex-WBC, most recently) question the use of a consumer price index (CPI) as a proxy for inflation. David suggested you can track all booms (and resultant busts) to times of cheap credit leading to rampant speculation on assets, driving inflation up and requiring aggressive use of interest rates to bring inflation back under control. He suggested a more accurate measure for inflation should not only include consumer prices but also asset prices. This way money supply and interest rates would be less volatile, there would be less times of cheap credit and we could move away from severe boom, bust cycles. This seems like a huge cultural shift in thinking as many Australians speculate on assets (especially property) which, if I understand this approach correctly, would mean at a macro level at least, all asset appreciation would now be controlled. I would appreciate your thoughts both on the theory and also the practicality of this approach. Pat
How do you view long term convertible preference shares with the interest rate tied to the BBSW and being mandatory convertible as an inflation hedge ?
Simple solution:
Open a Commsec account, apply for an international equities trading account with them, and buy as many Berkshire shares as you can. Ten years from now you will be a wealthy man!
Reading this blog, and some of linked material, got me thinking about something different but related.
Where did our $40 trillion go? All those dollars issued by governments are still out there somewhere. Who has them?
Governments have not been withdrawing dollars from circulation. They have, if anything, been printing more to fund their rescues and "stimulus packages". And I don't see any other mechanism by which dollars could be obliterated. They must have changed hands.
The answer to this question could be crucial to making sensible investment decisions for the coming round of inflation. Yes, I think inflation is inevitable, almost by definition.
It's an interesting point, but a needlessly complicated strategy to execute. The Austrian school has a similar but simpler suggestion, recognise that inflation is always a factor of the increase in money supply, and stop the massive money supply growth we've seen in recent decades. That would achieve much the same result, and would also mean we could stop our hunt for inflation hedges. But don't hold your breath.
Various types of floating income securities, bought at the right price, make sense. Playing devil's advocate, though, BBSW-linked income is far from a perfect inflation hedge. In fact, the out of control inflation I fear is likely to come from short term money rates being held too low, too long. But floating rate income securities bought at low enough prices to offer high yields to maturity are always interesting. High returns are inflation hedges.
Gareth, I'm late to the party but I have got here. I would see hedging or even taking advantage of inflation via businesses as a two prong attack. First those businesses with a low cost advantage are going to see their advantage become even more pronounced when inflation hits and tomorrow’s runaway costs/expenses lead to higher prices and so become a bigger issue in customer’s minds. Cost has already become a big issue because people don’t think they have any money any more and in this years letter to shareholders (pg 8) Buffett explains how GEICO is taking market share or 'exploding' (his word) as 'Americans are focused on saving money as never before'. Well this cost focus will escalate when inflation hits and those businesses unable to cope with cost pressures will yield further market share and ultimately profitability to those with a true low cost position. While investing in businesses with a low cost advantage is always a good idea it is an even better idea at the moment and becomes extremely relevant in inflationary times. Examples would be one of your favorites Gareth i.e. Corporate Express and another might be JBH or Fantastic Furniture.
The alternative would be buy businesses as already discussed that hold advantages relating to pricing power without significant capital requirements i.e. plenty of genuine goodwill (and it doesn’t have to appear on the balance sheet). For mine Billabong fits the bill as does Blackmores. While I don’t disagree with either the ASX or Cabcharge (in fact I like them) I would point out that there will be delays or restrictions in freely putting up their prices i.e. cab prices are controlled and only rise after the fact, meanwhile their operating costs go up first.
Thanks for the article Gareth.
After recently reading Nassim Taleb's books, this article (see link below) happened to cross my desk today. Whilst I have never heard of the hedge fund manager 36 South, they have just announced they are closing their "black swan" fund (after returning 236% last year), and opening an "Inflation hedge" fund.
What I'm starting to notice now is that a lot more people seem to be recognising the risks of severe inflation in the medium term, as opposed to discussing deflation risks. Or could this just be a result of the commentators I tend to follow?
http://www.bloomberg.com/apps/news?pid=20601087&sid=aMnfuo6KKyQU&refer=home
I would do it if someone guaranteed me that Buffet would live forever :-)
Hey Steve and Sam
I was born in 1925 in an outback town in South Australia to a labouring family and that without a calculator makes me
c lose to 84 y of age I began school in 1931 and when I grew out of my shoes and clothes, they were handed down to my sister of my brother. The replacement for me was either new or second-hand. We walked one mile to school.
My Grandparents were pioneers, having taken up the land wheat and sheep farmers on a small acreage. Once a month they would drive the old Model T Ford to Burra where we lived in our own house (paid for before 1929) bringing with them, all for gratis, produce from the farm. There was meat from sheep, pigs, a calf as well as Dairy products like milk and cream. I have often thought::------ had not they provided us with the “food from the farm” we would have starved. Later the Government came to light with ration tickets for all foodstuffs. (to-day people in such circumstances apply to Centre-Link and no ration tickets , but hands full of cash. in lieu thereof.
Lunch breaks from school saw many students trekking across the creek to the Salvation Army who provided hot soup for us. Again all of this was Gratis.
During school holidays my brother, sister and myself were taken to the farm by our Grandparents. What I want to highlight is the number of “Swaggies” on the road., i.e. Men walking the road and calling in at every farmers house looking for work --- any kind of work. If one or more of these men called at the house, they would mostly ask for a meal in return for some job, such as cutting wood at the wood-heap for a few hours, or maybe sharpen some tools or instruments or if they had any trade they would work at it for free. Gratis. If it was nearing evening, they some times were given a bed. I had never seen one of these blokes receive something from the farm without them doing something in return. Young men, Old men well spoken men. It was pathetic to see these men under those circumstances, but unable to do anything about it.
I could go on for hours telling you of how people lived during the Great Depression. Let us hope and Pray that what is in front of us ---- is not like I saw.
In what I read today was what you wrote from 10th to 12th. April and you mentioned about un-employment being about 5% . Well , Mr. Thomas J. Harbrow was correct in what he said. What he left out was probably due to his younger age. After 1929 unemployment rose to 10 per cent, and the thing to remember is the fact that there were very few Women who were in the workforce. They were at home looking after their children ( as they should be now), i.e. They should be at home with their kids and we would have much less crime.
..
Hey Steve and Sam
I was born in 1925 in an outback town in South Australia to a labouring family and that without a calculator makes me close to 84 y of age I began school in 1931 and when I grew out of my shoes and clothes, they were handed down to my sister of my brother. The replacement for me was either new or second-hand. We walked one mile to school.
My Grandparents were pioneers, having taken up the land wheat and sheep farmers on a small acreage. Once a month they would drive the old Model T Ford to Burra where we lived in our own house (paid for before 1929) bringing with them, all for gratis, produce from the farm. There was meat from sheep, pigs, a calf as well as Dairy products like milk and cream. I have often thought::------ had not they provided us with the “food from the farm” we would have starved. Later the Government came to light with ration tickets for all foodstuffs. (to-day people in such circumstances apply to Centre-Link and no ration tickets , but hands full of cash. in lieu thereof.
Lunch breaks from school saw many students trekking across the creek to the Salvation Army who provided hot soup for us. Again all of this was Gratis.
During school holidays my brother, sister and myself were taken to the farm by our Grandparents. What I want to highlight is the number of “Swaggies” on the road., i.e. Men walking the road and calling in at every farmers house looking for work --- any kind of work. If one or more of these men called at the house, they would mostly ask for a meal in return for some job, such as cutting wood at the wood-heap for a few hours, or maybe sharpen some tools or instruments or if they had any trade they would work at it for free. Gratis. If it was nearing evening, they some times were given a bed. I had never seen one of these blokes receive something from the farm without them doing something in return. Young men, Old men well spoken men. It was pathetic to see these men under those circumstances, but unable to do anything about it.
I could go on for hours telling you of how people lived during the Great Depression. Let us hope and Pray that what is in front of us ---- is not like I saw.
In what I read today was what you wrote from 10th to 12th. April and you mentioned about un-employment being about 5% . Well , Mr. Thomas J. Harbrow was correct in what he said. What he left out was probably due to his younger age. After 1929 unemployment rose to 10 per cent, and the thing to remember is the fact that there were very few Women who were in the workforce. They were at home looking after their children ( as they should be now), i.e. They should be at home with their kids and we would have much less crime.
..
Hi,
I have just read your article on the Great Inflation of 2012, hence some lateness in response. I always like to see other informed opinions on future outlook for inflation.
I look after the AUD Inflation Trading business at one of the leading investment banks in this niche market. ie, we buy, sell and originate Inflation Linked Bonds and Inflation Linked Swaps.
There are AUD$20b of existing Inflation Linked Bonds in the Australian market, with much larger markets in US, UK, Europe, Japan (yes!).
Concentrating on Australia, the Index used is the Headline Consumer Price Index published quarterly by the ABS. The basket measured includes food and oil, but not asset prices directly. The Aust. Govt has 3 current bonds (and possibly more soon) issued, a 2010, 2015 and 2020 maturity. There are also bonds issued by NSW, Vic, SA and Queensland. Finally, there are less liquid issues by infrastructure and other PPPs, often which are very closely linked to the underlying state government credit. The tenors are typically long (0-30yrs), which reflects the need for inflation protection over the long term.
While the market is predominately institutional (500k min size, 5m market parcels), many of the above securities are available to retail in 1k, 10k, or 100k min parcel size. There is far more awareness and developed RETAIL inflation linked market in Europe/UK/US.
So, for "perfect" protection against the headline inflation, CPI Bonds are the lowest risk, best matching asset available for protecting the REAL value of money over a reasonable term. Given long tenors, credit tend to be super high quality, which further makes them ideal as the BASE of any portfolio (and much much better than the great useless metal, gold). The need for inflation protection increases dramatically as one approaches retirment, an cannot afford to take downside risks to their real(often) fixed capital/income base. Those lucky enough to be younger hopefully gets alot of inflation protection through wage increases.
The cost of the lowest risk asset is a low real yield. As a guide, the Real Yield for the 2015 Aust. Govt CPI Bond is about 2.50% (+ actual CPI). So if actual inflation averages 5% over the next 6 years, then total return will be approx 7.5%. If actual inflation is 0%, then return will be 2.50% etc. Some securities have deflation floors. This 2.50% real yield should be compared to government 2015 Nominal bond at c4.25% (which give a Break Even Inflation rate of 1.75% for 6 years). Alternatively, it can be compared to cash at 3%.
Semi government CPI Bonds tend to have 50-100bps higher real yields, and some of the PPPs (eg county court of victoria) have Real Yields above 5% (+ actual CPI).
I spend every working day thinking about inflation, and there has never been a time in the last 15 years where the outlook for actual inflation is more uncertain. Significant deleverging and deflationary forces, against significant and unprecedented Goverment response, including Quantitative Easing in UK and US (aka electronic printing press). On balance, I favour higher inflation as governments cannot afford deflation, an hence will over-respond, rather than under-respond.
On other asset classes, property is eventually a good hedge. Initially though, one may have to suffer capital mark-to-market losses as in very high inflation environment, interest rates will rise, and this will lower property prices initially. So as inflation rises, property will be falling. Ditto equities in general. Ultimately, sustained inflation will increase rent (the earnings), and over time, will dominate the interest rate effect - but it could take many years (and probably not until inflation threat has subsided and interest rates are falling).
Equities have been well covered elsewhere - I like LPTs and infrastructure companise more and more as both leverage and prices reduce. Sydney airport (as a great shopping centre) has many inflation linked rental streams. Health sector also fits in well (especially if we are hedging longevity too!!)
Commodities (eg wheat, corn, coffee, oil and useful metals) should be reasonable "real investments" over time, but with significant volatility and little income. Commodities are generally denominated in USD, so alot of their perfomance is really a short position in USD. Beware.
So, a exact inflation hedge will include only CPI Bonds.
However, a higher returning inflation portfolio may have CPI bonds as the first base investment, but also some direct property, selected equities, low-levered selected LPT/infrastructure, floating rate securities and perhaps commodity exposure.
I am fine to expand further - especially if this increases awareness of this little known, but very important asset class
agree definately a key person risk and he's getting on a bit don't know what his successors are like
Andrew
Thanks for your post. As a punter who is interested in macro economics I have been pondering this question and was wondering if inflation linked bonds existed in Australia. I know that the Buffet books mention such bonds in the US as an inflation hedge and you have answered my query. Are you able to expand on how a retail investor after an exposure of say 10-100K would access these bonds?
Thanks
I would suggest a retail fixed income broker (we are wholesale only, but often the retail broker will call us to get the bonds). I can suggest 3 potential retail brokers who have dealt in CPI bonds. I don't want to advertise companies on this forum - but happy to pass names thru editors, (or publish them if they are ok)
[...] read Gareth Brown’s views about the potential inflation risks arising from government stimulus. What’s your [...]
Terrific information:D Will come back again
Today I read an article which summarises some thoughts delivered by respected value investor Seth Klarman at a recent speech, some of which involve the potential for inflation and how he's positioning Baupost's portfolio for it. Here's a link to the article Seth Klarman: Why Most investment Managers Have It Backwards.
An interesting post today on John Hempton's blog (reproduced from his archive). Here's a link to it.
More than 12 months have passed and I'm sure everyone has moved on. But some interesting comments on Seth Klarman's inflation hedges in a recent meeting - see gurufocus notes here (http://www.gurufocus.com/news.php?id=95192#)
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