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July 20, 2009

The Curious Case of the Inflation Chameleon
by Tyler Mordy

An abrupt change has occurred in financial market expectations: a near-universal consensus has emerged that an inflation crisis is inevitable and imminent. Why the sudden shift? After all, deflationary depression scenarios prevalent three months ago have been quickly abandoned, instead substituted with 1920s Weimar-style inflation forecasts.

Over in ETF land, a similar phenomenon can be observed -- investors are racing into all types of inflation insurance. Over the 12 months ending June 2009, Barclays' Treasury Inflation Protected bond ETF (NYSEArca:TIP) experienced inflows of USD 4.95 billion. And, according to the World Gold Council, identifiable investment demand for gold, which includes ETFs, was the largest source of growth in the first quarter, reaching 596 tonnes (up 248% from the first quarter of 2008). The figures show a record level of investment into global gold ETFs, with total demand soaring 540% over last year to 465 tonnes (at today's spot prices, approximate value of USD 15.4 billion).

What gives? Are these positive investor flows accurately predicting imminent inflation? Before responding to that question, it will be helpful to briefly define some terms and common misconceptions. Most important to note is that official gauges of inflation narrowly focus on consumer price-level stability (i.e. the CPI index). We take a wider perspective, viewing established measures as either flawed or incomplete. Inflation is a much more deceptive creature ... developing like a cancer and often difficult to diagnose. As such, a more comprehensive definition of inflation is necessary. Broadly speaking, we must separate symptoms from cause. The cause is always monetary in nature. The symptoms are many. For the sake of this article, we will speak to only two of these manifestations of inflation, price inflation (i.e. CPI) and, importantly, asset price inflation (i.e. prices of commodities, housing, etc.) Other symptoms of monetary inflation include external account imbalances, wealth transfers and artificial pricing of risk (see Wilfred Hahn's June 2009 "Global Spin" for a complete list).

Consider the period from 1982 to 2007. Consumer prices, as measured by the CPI, crept up by approximately 2% annually. Inflation was officially deemed benign. But was it really? During that period, asset prices were wildly inflating (most notably home prices). This occurred during the great "financialization" boom as Wall Street manufactured an increasingly large supply of financial instruments (including the attendant leverage). Its effect was to divert monetary inflation (and debt creation in the non-bank sector) away from core consumer prices, instead stoking prices of financial assets.

Symptoms of Monetary Disorder. Misdiagnosed asset price inflation is problematic for multiple reasons. For one, distortions in pricing structures can lead to confusing signals for a market-based economy. Market participants may interpret price increases as underpinned by real demand, when these trends are merely driven by credit and debt. Of course, these misreadings lead to a grossly "maladjusted" economy and deviated prices.

Some investors have been alert to this less obvious form of inflation ... reacting by investing in unconventional asset classes. Consider commodity-linked ETFs. The United States Natural Gas ETF (NYSEArca:UNG) has had year-to-date inflows of over USD 3.4 billion, while Deutsche Bank's Commodity Index Tracker (NYSEArca:DBC) has seen its asset base rise by USD 1.75 billion over the same period. Many have criticized these vehicles for encouraging speculation and driving prices of key economic inputs upward. That may be true. And, to be sure, we view commodities differently than traditional asset classes and recognize different dynamics at play. But, in many ways, we are sympathetic with the speculator. Policymakers and central banks around the world are engaged in the largest fiscal and monetary reflation orgy in recorded financial history ... creating an environment of negative real rates and forcing investors further along the risk curve. How then should investors react?

Portfolio Antidotes. With such dangerous and unprecedented monetary dynamics, investors will need to protect portfolios ... staying alert to both traditional and non-traditional inflationary trends. Admittedly, that is never an easy task. Making matters more difficult, a seismic shift in global financial and credit markets is taking place. Investment strategies that worked well over the last quarter century are not nearly as relevant in today's market climate. As junk bond king, Michael Milken, has recently noted, "the past can't pay you interest."

In the 25-year period up to 2007, consumer price disinflation and rising asset prices were a consistent feature of the investment landscape. Portfolio managers became accustomed to a regular and fairly predictable business cycle. During expansionary periods, successful investors loaded portfolios with high-beta investments and cyclical plays. Conversely, when monetary policy was more restrictive, a rotation into longer-dated bonds proved to be a prudent strategy.

This cycle is much different than the average postwar experience. The world is trying to go back to business as usual, but most of the players lack experience in a period of declining asset prices, shrinking balance sheets and high debt levels. And, there's overconfidence in the capacity of Keynesian credit pump-priming to resolve today's economic problems. While central banks are increasing reserves on the books of depository institutions, outstanding credit is not commensurately expanding (see chart on Page 2).

The monetary landscape has certainly changed and calls for a different approach. How best to construct portfolios going forward? As always, the first line of defense is running balanced, diversified portfolios. Most important for this new period, however, is that a thematic global portfolio approach will be mandatory. Fortunately, ETFs are tools that lend themselves well to this style of investing, providing exposure to all types of theme-based asset classes. In an environment of monetary disorder and deleveraging, portfolios will need to be postured for protracted currency debasement (gold stocks and foreigncurrency bonds), slow growth, wealth transfers (Asian equities), and other special situations (infrastructure and energy alternatives).

Inflation Outlook. A return to a debt-fueled economic expansion based on rotating asset bubbles is unlikely any time soon in high-income nations of the world. Correspondingly, in the medium term (approximately 18- 24 months), the consensus is underestimating the deflationary impact resulting from the end of a 60-year credit expansion in the US. During that time, the U.S. experienced a four-fold increase in private debt issuance (from 43% of GDP to 175%). History has shown that post-bubble contractions can take several years to work off the excesses built up during the boom. Strong deflationary trends are likely to persist.

That said, we are in uncharted waters in the global coordination of easy monetary policy and the expansion of government liabilities. According to Grant's Interest Rate Observer, monetary stimulus in the U.S. is on track "to be ten times greater, at least, than the average policy response to the 10 preceding post-War II recessions." High profile economists are urging central banks to act "irresponsibly", as a way of softening the debt crisis and the deleveraging that still needs to take place. Others are advocating a 6% inflation target. Indeed, we have entered an era of monetary anarchy. While official levels of CPI inflation will stay muted for some time, other, less transparent, forms of monetary inflation will be rampant. Investors will need to be vigilant to these risks and position portfolios accordingly.

Tyler Mordy
Hahn Investment Stewards & Company Inc.

Hahn Investment Stewards & Company Inc.
Global Fund Management & Investment Counsel
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