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Examining The Consensus’ Case For Combating Inflation
Malaysia Perspective | 09 June 2011

By iFAST Research Team

While governments attempt to battle inflation and control rising prices through measures such as allowing their local currencies to appreciate, it remains to be seen if it will be sufficient to dampen recent price acceleration.

In the face of rising cost-push inflation, the consensus view would be to invest in real assets such as gold, real estate, energy and soft commodities in order to benefit from rising nominal prices and as a store of real value. While the view is definitely interesting and appealing, questions remain over the plausibility of the case put forth by consensus. Even though the consensus view might be attractive, it is nonetheless important to take a closer look at their advocated case.

The energy sector is one of the few sectors that typically benefits during periods of rising inflation. Oil prices have been rising as a result of the turmoil and worry of contagion in the MENA region. Whether the current rate of oil’s price appreciation is sustainable is anyone’s guess given the nature of uncertainty in the Middle East.

With the run-up in oil prices already factored into the prices of many of the big oil integrated companies, investors might be late to the party as the index measuring the performance of equities in the sector have notched up returns of almost 50% since August 2010 (Chart 1).

Chart 1: S&P 500 Oil & Gas Index Performance

Taking a closer look at the valuations of the sector, our research shows us that the sector’s P/E ratio has risen from its 1-year low of 9.3x to equal its 1-year average of 10.6x as of 14 March 2011. Comparatively, global equities as measured by the MSCI AC World Index, currently has a P/E ratio of 12.5x as compared to its 1-year average of 13.3x. Thus, Taking a closer look at the valuations of the sector, our research shows us that the sector’s P/E ratio has risen from its 1-year low of 9.3x to equal its 1-year average of 10.6x as of 14 March 2011. Comparatively, global equities as measured by the MSCI AC World Index, currently has a P/E ratio of 12.5x as compared to its 1-year average of 13.3x. Thus, one could induce that on a relative basis, the oil & gas industry might have already experienced a run-up in its valuations and might not have as much upside room to it as compared to global equities.

Furthermore, given the positive statements and positioning of the Saudi and American governments, it remains to be seen if oil prices will be able to hold onto or build on its gains to edge higher.

Regardless, we do not advocate investing directly in oil futures which require a rise in price for an investor to profit. We rather investors gain exposure to the energy sector via the relatively low-risk big oil integrated companies with their robust balance sheets, steady free cash flows and diversified sources of income.

A hungry man is indeed an angry man. One of the key underlying reasons for the turmoil in the MENA region has been the financial squeeze on the population due to the rise in food prices. According to estimates by the Economist Intelligence Unit, households in Egypt and Saudi Arabia spent approximately 46% and 27.6% of income on food respectively in 2010, a sizeable chunk of a household’s income.

With the global population expected to grow by over 700 million people to reach 7.6 billion by 2020, the demand, competition for and spending on food is likely to intensify globally in the near future. Further, with falling amounts of arable land and what was once freaky weather becoming more the rule than an exception, the agricultural food chain is in-line for more potential food shocks.

Similar to energy, investors might be late to the party as there has been a significant run-up in the prices of agribusiness companies (Chart 2)

Chart 6: S&P 500 vs US CPI

Likewise, we do not advocate investing directly in soft commodity futures which require a rise in price for an investor to profit. We rather investors gain diversified equity exposure across the various segments in the agribusiness value-chain to reduce the risks (e.g. weather anomalies) which severely affect the prices of soft commodity futures.

Inflation-Linked Products

During times of rising inflation, inflation-linked bonds, more commonly known as Treasury Inflation-Protected Securities (TIPS), are one of the most obvious products to invest in. TIPS, which are indexed against inflation, have a par value that rises with inflation as measured by the Consumer Price Index. The coupon payments of such securities are inherently tied to inflation levels as the interest paid out is based on the adjusted principal, thus capturing any rise in inflation. With the difference between the yield of 10-Year Treasury bonds and inflation-linked bonds at its widest since July 2008, investing in this niche sector could reap dividends for those expecting inflation to rise.

Despite the purported safe haven from inflation, TIPS, like almost any other fixed income security, are exposed to other risk factors such as interest rate risk as well as duration risk. Further, while most inflation-linked products are tied to inflation indices, these indices are typically formed in developed countries which are currently not experiencing similar rates of inflation as those found in emerging countries. For example, the consumer price index (year-on-year) for the US and Singapore rose 1.6% and 5.5% respectively in January, a clear and significant gap in the rate of price appreciation.

Thus, even though investors might be able to get exposure to such instruments based in other developed markets, they would not be sufficiently protected against a higher rate of inflation in Singapore.

Real Estate

One of the most common assets recommended for long term holding has been real estate. In countries and cities where land is scarce and supply is tight, real estate prices generally rise over time. Taking Singapore, a land-locked country as a prime example, the differential between the city-state’s real estate price appreciation and its consumer price index is as shown in Chart 3. Apart from the periods encompassing the Asian Financial Crisis, bursting of the Dot-com bubble and the recent Great Financial Crisis, real estate property prices have generally managed to appreciate significantly higher than the consumer price index in the Lion City.

Chart 3: Singapore’s Real Estate vs CPI Appreciation

While real estate does look like a good hedge against inflation, just how many investors have the purchasing power to simply place a down-payment of approximately 20% of a house’s value? To further complicate matters for investors looking to use real estate as an investment tool, governments across Asia have been introducing various legislative measures to restrict property speculation in an effort to curb rising real estate prices (e.g. China, Hong Kong, Singapore).

Thus, while real estate has proved its worth in recent times (excluding the fiasco that is the housing markets in developed markets), the regulatory impact on the sector might dampen its future appeal as a hedge against inflation.

The notion that gold, as a real asset, protects its value during times of inflation is perhaps one of the most frequently touted theories/stories in the investment realm. To eliminate accusations of time bias, we have decided to compare the returns for the past 40 years for gold and equities (Chart 4).

Chart 4: S&P 500 vs Gold

As seen from above, gold has managed to reap hefty returns of over 30 times the initial capital invested (both equities and gold were based at 100 in December 1971). From a glimpse of the chart, it would appear that gold trumps equities hands down. But, is the precious metal really that shiny and will it be able to make your portfolio shine?

Thinking back to the 1970s-1980s, leads one to recall a flood of major events. From the abandonment of the Bretton-Woods agreements in August 1970 (which led to gold being unpegged to the dollar), to the 1973 oil crisis, Iranian revolution and a subsequent period of stagflation in the 1980s which saw Paul Volcker raise interest rates to an all time high of 21.5% in December 1980 to slay inflation. The period which saw gold make its first ‘run’ was indeed, during a very different time.

In the 2000s, the performance of gold was deeply aided by the listing of the SPDR Gold Trust ETF in 2004, which opened up futures of the precious metal directly to investors and speculators, leading to heightened interest in and direct access to gold futures for the common man. The outbreak of diseases such as SARS (2002-2003) and a variety of animal-related flu strains together with the Great Financial Crisis of 2008 and its after-effects has aided gold as it embarked on its latest ‘run’.

Despite the similarities of recent times (unrest in the Middle East), things today are pretty much different. Given that expected inflation rates in the near future are expected not to deviate much from the relatively stable rates of the past decade, a return to stagflation and interest rates of 21.5% as per in the 1970s-1980s seem absolutely unrealistic.

Although it may appear from Chart 4 that gold has outperformed equities in the long run, the average annualised returns of the S&P 500 as well as that of gold as shown in Chart 5 tell a different story. As can be seen in Chart 5, over the rolling short-term periods, gold has actually outperformed equities, while the reverse is true over the longer 5 to 20 year rolling periods.

Chart 5: Average Annualised Returns

While gold has outperformed equities in the short term, equities have actually outperformed the precious metal over longer time frames. A plausible reason could be the 2 major spikes (highlighted in Chart 4) in the performance of gold during extremely uncertain and trying times. Thus, investors looking to invest for the long term, which usually minimises the effects of short-term price spikes or dips, should consider investing in equities as evidenced by the above.

Closing The Case
The case for investing in equities couldn’t be clearer as shown below in Chart 6.

Chart 6: S&P 500 vs US CPI

Apart from a brief period of stagflation in the late 1970s and 1980s, equities have subsequently managed to significantly outpace the growth in the consumer price index. In closing, a well-diversified portfolio should provide investors with the protection required during an inflationary environment. The one thing investors shouldn’t do is to sit back and wait for the tide of inflation to pass, or they might find their portfolio take an expensive and involuntary haircut, courtesy of inflation.

* The Research Team is part of iFAST Capital Sdn. Bhd.

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