Investing under pressure

It's necessary to rethink one's investment strategy in inflationary times. Here's a perspective on how and where to look for opportunities

There are many reasons for the current rise in inflation, but persistent commodity price increases are a key catalyst. Costs of significant raw materials (such as iron ore and aluminium) and production energy costs (such as coal and natural gas) will continue to impact costs of production equipment and components. The main issue is whether the upswing in energy and commodity prices represents enduring global demand and supply developments, and therefore a lasting shift in prices to higher levels.
    If commodity prices keep rising, headline inflation could remain elevated for longer, lifting people's inflation expectations and putting upward pressure on wages as households increase resistance to the erosion in purchasing power. In such a scenario, inflation could become more generalised and entrenched.
Six things to watch out for
Six factors could pave the way towards a higher inflation environment over the longer term.
Global money supply growth: Strong global economic growth and the resulting effect on inflation arose from overly expansionary monetary policies in industrialised countries, particularly during 2002-04. Credit expanded rapidly in many countries, spurring aggressive demand for assets, goods and services. The availability of relatively cheap credit until recent times also contributed to highly speculative buying in assets and commodities markets. With monetary policy remaining accommodative and real interest rates being eroded by inflation, inflationary trends might not subside.
Energy supply challenges: Supply of traditional energy sources has suffered a variety of disruptions caused by weather anomalies, geopolitical instability, insufficient investment in capacity throughout previous decades, and rising costs for commodity producers. The rising cost of oil and gas is also spurring increasing interest in biofuels and other alternative sources of energy. However, many of these are produced from grains, which are in turn escalating in cost.
The food price shock: Food price inflation is likely to endure longer than many people expect, with agricultural commodity prices expected to stay high for the foreseeable future.
Central banking policies: Central banks may have little choice but to live with inflation levels above their targets (and governments with relatively sluggish consumption growth) for years to come.
Shifting demographics: We expect there will be relatively more consumption and less savings worldwide in the years ahead. Disturbingly, the pattern of per capita oil consumption versus per capita income in emerging markets is closely tracking that of industrialised countries – and similar patterns are emerging in food consumption.
Socio-economic threat: While the pace of urbanisation in larger emerging markets had a disinflationary effect in the past, there are warning signs that this situation is likely to recede in years ahead. China has been a significant influence, with its urban population level steadily increasing since pro-market reforms began in the late 1970s. This contrasts with India's urbanisation rate, which is just 29%, compared with the 75% average across the industrialised world.
Investment implications
History shows that returns from equities and bonds suffer when inflation surges. Upswings in commodity prices raise the cost of materials, curb corporate profits and push inflation and bond yields higher.
    However, high inflation can provide opportunities for some companies with few competitors, those with sales exposure to high-growth sectors in emerging markets such as infrastructure and consumer goods, those in regulated sectors that let revenues increase in line with inflation, and those with links to real assets like hard and soft commodities, precious metals, oil and gas and real estate.
    Quality companies with moderately high levels of debt and strong cash flows and interest cover are likely to benefit from an inflationary environment. During periods of high inflation, the value of outstanding debt is eroded. If there are sufficient cash flows to support the debt structure, such companies can efficiently use capital for investment.
    An examination of global asset class performances from 1972 to early 2008 show real (inflation-adjusted) returns from energy, precious metals, agricultural commodities and gold easily outperformed those of traditional equities, bonds and cash during periods of high and rising inflation.
    Importantly, the starting point for an investor in any asset class, particularly equities, is critical. Returns from equities would have been substantially different if one had invested following the sharp global sell-down in 1973-74. Global markets peaked on January 5, 1972, and fell 41.9% to bottom in October 1974. Since the highs of October 31, 2007, global markets have declined by 21.3%.
    Investors entering the market following previous large declines have reaped substantial rewards over the following years. We believe such an opportunity exists following the most recent equity market sell off.
Conclusion
    With the powerful momentum in commodity price trends, further new price records over the short-term and potentially the medium-to-long term are likely scenarios. From an investor's perspective, inflation risks are sufficiently serious that investors should consider protecting themselves via defensive assets and focusing on an investment's real rate of return. And real return assets such precious metals, hard and soft commodities and infrastructure are identified as among those likely to thrive in an inflationary environment.

Fran Lebowitz  - "Life is something to do when you can't get to sleep."