Inflation alert

As central banks hit the printing presses, the risks of a global inflation outbreak are rising. It's time to get prepared.

PORTFOLIO POINT: As fears of a global inflation outbreak rise, it’s important to assess whether your portfolio has the right mix of assets to combat this risk.

I had just finished lunch at a restaurant this week when a local identity, who is aged in her late 70s, came up to me in a state of some agitation. She came straight to the point: “My nephew wants to borrow $10,000 from me to plunge into the silver market. What should I do?” The nephew, who has a part-time job and already owes the old lady money, had just been to a seminar where they told him that silver was the place to put your money, given what was happening in Europe and the US.

You can imagine what I told her. But fascinatingly, on the very next day, one of our leading banks – in a presentation under the Chatham House Rule – warned their business clients about the possibility that the mass European and American money-printing operations could lead to a bout of global inflation in a year or two.

These two apparently unrelated events have led me to talk about what is happening on the world stage at present, and some of the strategies we might consider to hedge against a longer term inflation risk.

I have never seen money printing conducted on the scale we are currently witnessing. Readers may pick me up, but to my knowledge the last time this happened was in the so-called Weimar Republic in Germany, and it certainly led to rampant inflation. But that doesn’t mean the same thing will happen this time.

At the moment, huge slabs of liquidity are being created by central banks in the US and Europe, which are lending to their banking systems at token rates. Some of this money goes to European government bonds (on which European banks are losing more money), but much of the money is finding its way into speculative hands and pushing up sharemarkets. In a strange way, in the current environment when a country announces bad news, it initially sends markets down, but then it triggers the possibility of a new wave of money-printing, so markets can rise despite bad news. Everything in me suggests that when central banks take these sorts of high-risk strategies, it will end in a sad story. There remains a clear danger of a nasty end to the European situation. There are a lot of people who have a different point of view and believe markets are headed for a new bull phase and, as we are in uncharted territory, no one can be sure they’re right.

Certainly, we are seeing a slowdown in China and the likelihood that the increase in supply of commodities will cause a weakness in price over the next year or two. And again, that’s what the sharemarket is telling us via lower mining share prices. But the market is not signalling that there is going to be a nasty European end, although market signals can be obscured by the liquidity created by the money-printing presses.

At the moment, there are very few signs of inflation in the US and Europe, because consumer demand remains depressed and a great deal of the money is being channelled into buying bonds or into other areas that are not stimulating the economy. At the same time, governments are contracting and there is deleveraging. That means that inflationary pressures are not very noticeable at this point.

But if we keep going, and there are more rounds of money-printing in both Europe and the US, then in due course paper money will be downgraded and you will start to see a rise in inflation – or at least, that’s one of the clear possibilities.

So what sorts of investment strategies are available to us to combat inflation that is not linked to a boom? Unfortunately, inflation causes higher interest rates as central banks and governments try to control it; that means high borrowing is dangerous. It is very easy for the combination of high interest rates and inflation to be transposed into a sort of stagflation, where the economy is depressed but inflation remains high.

The most obvious strategy if you are looking to hedge your risks in this area is to make sure at least part of your assets are in bricks and mortar, because in the inflationary period the costs of building will rise. The problem is that the demand for many commercial properties may not enable them to match inflationary rises. It underlines the need to own your own house in inflationary times, because in due course house prices will respond to higher building costs. And as an indication of what the Chinese think might happen, we have seen in the last month a substantial rise in Chinese buying of inner city apartments in Sydney, Melbourne and Brisbane. Enormous towers are being planned for Melbourne, in part aimed at Chinese buying off-the-plan. I can’t tell you how long the current rate of Chinese buying is going to last, but at the moment buying looks stronger than we have seen for some time and it coincides with the fact that in China, apartments yield far less in income than in Australia, and the Chinese government is not anxious to push the price of apartments higher for fear of creating a bubble.

It is early days, but we may be looking at an increase of Chinese buying of our inner city real estate, because they don’t want to hold vast amounts of currency paper, which can be badly affected in inflationary times. I do emphasise that we are only looking at less than a month’s activity, so I could be getting ahead of myself. We will be watching this very closely in the next few months. The second area of inflationary protection is in stocks that have income tied to inflation. The best stocks in that category are stocks like toll roads, and Transurban is an obvious example. It is a tragedy for the Australian market that we lost ConnectEast at a low price, because it was an even better inflation hedge than Transurban. It’s worth looking around for other stocks that provide a similar hedge. The problem is that many are highly leveraged and that leveraging dissipates their inflationary benefit.

Another area that normally we might not classify as an inflationary hedge is oil and gas. Oil has the term 'black gold’ and often performs well in times of inflation because it is a real asset, but of course if demand globally is too depressed, it will also fall. Nevertheless, a portion of energy assets – say Woodside or Santos – in your portfolio is not a bad hedge. Finally, there are the classic inflationary hedges of gold and silver. Just over a year ago, I wrote about the attractions of Newcrest shares; since then, the shares have fallen about 26.5%.

It is high risk to have a substantial portion of your portfolio in gold or silver (or gold and silver shares), but as part of your anti-inflationary mix they make good sense. In taking an anti-inflation stance at this point, you would be moving well ahead of the game because I can’t see inflation breaking out in the next 12 months. But down the track, there will be an increased danger of inflation. Despite that danger, my elderly lady should not advance money to her nephew, because he has no money and it’s akin to going to the races on borrowed money. She can’t afford the loss.