There are several varieties of inflation: cost-push inflation, which can derive from a number of factors, including higher commodity prices or wage-price spirals; demand-pull inflation, where excessive aggregate demand causes shortages and pushes up prices; and monetary-driven inflation, where governments increase the monetary supply in attempts to devalue their currency and manage their fiscal obligations. Currently, any fears of inflation are centred on the third variety. Since the U.S. has not experienced monetary-driven inflation since World War II, investors can be forgiven for not knowing how to react to it. And when coupled with an economic downturn, extensive deleveraging and significant shifts in global economies, coping with inflation can be particularly challenging.
The difficulty lies in identifying an investment strategy that will work in such an environment. This challenge is further exacerbated when many traditional “safe harbour” investments are severely overvalued. Added to that are the fundamental shifts in global economies, which are causing many investors to rethink their global allocations.
Bonds
When starting yields are as low as they are today, there is an expectation of very poor future returns. However, the recent unexpected rally in U.S. Treasury bonds is a reminder that in the midst of fiscal uncertainty, there will still be a flight to familiar or traditional “quality.”
Corporate bonds
While governments are seeking to reduce their indebtedness and limiting the cost of their debt, high quality corporations with strong cash positions can piggyback on the continuing low-rate environment, giving investors the benefits of compression of credit spreads.
Equities
Inflation has an inverse impact on real earnings growth and price-earnings multiples, resulting in the observation that both too much and too little inflation are problematic for equities. The combination of price appreciation and dividend yield has to be “just right” to support equity returns, with dividend yields expected to account for a greater proportion of equity returns.
Commodities
One major outcome of “easy” monetary policy is high commodity prices. Commodities and commodity-related equities have suffered a significant pull back over the last few months. Although it is realistic to be secular bulls on commodity prices over the long term as the global expansion continues, the near-term outlook remains cautious.
Currency
No matter what the doomsayers may tell us, the U.S. greenback (and Treasury Bills) remains the reserve currency. In a stagflation environment, these will still be safe harbours. For Canadian investors, reconsider hedging strategies as the Canadian dollar approaches parity once again.
Alternatives
Alternative assets, including real estate, gold, infrastructure and hedge funds, remain an interesting choice during a period where either inflation or deflation may reign. “Real” assets maintain their value and true absolute return strategies (pure alpha from market neutral long/short strategies) are independent of economic conditions.
However as demand for these assets continues to outpace supply, it will remain difficult for most investors to find good opportunities. Agency risk and cost is also a concern for all but the largest (direct) investors.
Inflation or deflation—who knows? Either way, the economic prospects are so gloomy that any defensive investment strategy could work.