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Monday, February 18, 2013

Appropriate asset strategies for inflation

What assets will appreciate faster than inflation in a high-inflation environment?  

Certainly not stocks. Before inflation materializes, yes, but not when inflation has materialized. Inflation creates information inefficiencies, as corporate accounts become in-transparent, and it becomes very hard to see which company is profitable or not. Furthermore, due to high variability in prices, financial and operational planning becomes more difficult, tending to suppress investments. The real tax burden on companies increases, as profits become artificially inflated by timing differences. Finally, inflation will drive up interest rates, increasing the cost of capital for companies, making profits less valuable. In the inflationary period starting in the late 1960s (when Nixon was printing money to pay for Vietnam) the stock market was nearly flat until 1982 (though volatility was high), and corporate earnings increased less than inflation (average P/E multiples on the S&P 500 where in the range of 6-8).

Certainly not real estate. Cost of financing will increase, driving up required real estate yields and driving down valuations. As rents are adjusted with a time-lag, income from real estate asset will lag inflation. At current valuations (which in spite of the decline since 2008) house prices are still high in a historical context. Real estate will be worse investments than common stocks when it comes to preserving wealth. In the period up to when inflation materializes and interest cost adjust (which is what is happening now, foreseen to continue for at least 18 months) real estate will provide superior returns, but will be punished with a vengeance later on in the cycle. Back in 1978, my father paid for his first one-bed-room apartment with an amount corresponding to 6 month salary (and he was an entry level manager at the time).

And (for the sake of completeness) certainly not bonds or T-bills. If you among the few who might wonder why, google the term "bond duration" and you will know.

So, what is left then? Commodities? Farmland? Treasury Inflation Protected Securities???

Jim Rogers is a fan of the first two. His thesis is that purchasing power will increase more in Asia, leading to Asians eating more meat, which will push up the price of grain and increase yield on land. And there is some truth to it. Commodities performed relatively well during the high-inflationary period of 1968-1982, only to get hammered in the 30 years thereafter.

Treasury Inflation Protected Securities (TIPS) may provide some support, as the existing ones will be bid-up, as their (already very low) yields are likely to become even lower.

The key to survival in a high inflationary environment lies in capital allocation decisions. The optimal strategy is:

1. Purchase real estate with low maintenance and running cost, leverage your purchase to the max, and fix the interest rate for as long as you can. This is an asset that you can live in, and if you have a wood-fired oven to keep you warm, you can always manage variable costs....

2. Allocate a percentage of your remaining portfolio to precious metals (suggest 35%). A lot of people out there are very bullish on silver due to a favorable supply/ demand situation (usage in electronics keeps increasing, but supply from silver mines keeps experiencing larger and larger production cost). Also, in the extreme case of a hyper-inflation environment, where precious metals take over as currency (yes Armageddonists, you will love this!), Silver is more practical than gold, as coins can be used for everyday purchases due to lower value. Silver, however, has higher transaction cost when you want to buy and sell it and requires more storage. I prefer gold to silver, though gold has been very overbought and mid-term price direction is uncertain.

3. Allocate a percentage of your remaining portfolio to shorting US treasuries with long duration (suggest 20%). There is huge upside in such as position, as bond values converge to zero, you will at least double your money. Just remember to keep re-investing proceeds, to maintain the same exposure all the time (doubling the nominal value of your cash might not be enough to give you inflation protection).

4. Allocate a percentage of your remaining portfolio to financial service stocks (suggest 40%), especially financial brokers arranging ETFs, those that have proprietary trading activities in equities and commodities, and do NOT have bond market making activities. Money will pour into commodities, ETFs for all kinds of real assets, in a rather headless fashion, and investment and commercial banks will skim the margins. The size of their balance sheets, equity under management etc should increase with the rate of inflation, and inflation will reduce impairment risk of assets. When inflation is killed (no risk of this next 5-8 years though) banks will be in a pile of pooh-pooh, as they will have allocated a lot of capital to intrinsically unprofitable investments. However, whoever comes after Helikopter Ben needs to have a plan no cause a collapse, and warning signs will be ample.

5. Producers of farmland equipment can also be a good play for the next 5 years. Large-cap farming equipment producers with low P/E ratios have the potential to be re-priced as growth stocks when the market overshoots. And there will be acquisition plays as larger producers swallow the smaller ones with borrowed money.