Sent: 22-11-2012 18:24:02
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Improved Equity Returns to Come Before Inflation
Fears of inflation have prompted calls to abandon financial assets in favour of gold. Even if the more extreme inflation fears are to be eventually realised, investment decision making should take account of important transitions between current conditions and the potential inflation outbreak. Resort to gold might be premature.
One of the themes in a series of recent meetings with investment professionals from family offices through Asia was the likely emergence of inflation.
Not all were convinced that inflation was a problem. Some, however, were preoccupied with the possibility that central bank security buying programs would lead to an inflation outbreak with a later surge in interest rates damaging already struggling equity markets.
A small minority was prepared to skew their portfolios entirely to prepare for this eventuality.
So far, there is scant evidence of money supply growth creating inflation pressures. If anything, inflation is tending to drop below the targets for which central banks have been aiming.
Of course, we need to be clear what inflation we are talking about. Over the years, use of the term inflation has become synonymous with changes in the prices of consumer goods and services. Globally, inflation of this sort has been heavily constrained by technology and the greater freedom of manufacturers to tap a wider range of lower cost production locations.
The prices of many goods have, consequently, been declining. Prices have risen most rapidly where there has been the least competition in markets. Prices of electricity, health care and education have risen more rapidly than the headline consumer price indicators.
As the shackles on financial markets have been loosened, excess money supply has been able to move more freely into a wider range of markets that had once been excluded from everyday investors. Real estate, art, horse racing and government bonds are just a few alternative avenues into which money can flow.
U.S. government bond prices, gold bullion, the price of the Australian dollar and the price of a share in Apple Inc have all been inflated.
Because the inflation has not appeared where people most wanted to see it, there has been a tendency to ignore the signs. There is an element of hypocrisy in this. A tenfold rise in the gold price is not inflation but a tenfold rise in the price of bananas is inflation. This makes no economic sense.
Milton Friedman opined in the 1970s that inflation was always a monetary phenomenon. His views gained popularity in part because of their simplicity. If the money supply was growing faster than output (and the velocity of circulation was not changing) prices had to be higher. In his mind, the relationship was a straightforward one.
The current experience suggests that Friedman was probably wrong when he described inflation as always being a monetary phenomenon. More accurately, he could have referred to it as a credit phenomenon. Money supply growth without credit expansion may have no effect on inflation.
For those on the lookout for inflation in the current economic cycle, the lacking ingredient is not money supply growth but credit expansion.
Nonetheless, for some, the expanded money base constitutes a ticking bomb. A simple and unanticipated change in animal spirits could quickly revive bank lending to create an environment in which inflation could thrive.
While there is some theoretical chance of such a scenario playing out, the inferences being drawn about likely investment returns are often not taking account of the linkages through which monetary policy has an effect.
Moreover, one suspects that most of the world's leaders would, given the experiences of the past few years, welcome the possibility of the ticking bomb actually exploding. Dealing with runaway credit expansion may be a preferred alternative to the financial crises with which they have been grappling for the past few years.
Monetary policy does not work symmetrically. Prolonged expansions of the money supply might result in little or no effect on activity, as we are seeing. On the other hand, in the seemingly unlikely event that credit expansion were to escalate unexpectedly, central banks could act to bring it to heel with some confidence knowing that activity rates could be quickly halted and demand for credit cut back.
Even if central banks were slow to respond to a resurgence of bank lending, investors should not be too unnerved.
A credit expansion will be associated with an improvement in demand for goods and services. If prices also rise, company revenues must rise, too. As the limits of productive capacity are reached and higher levels of demand look sustainable, corporate investment spending will probably rise. Government fiscal positions will improve.
All of this sets the tone for significantly improved stock market returns. It is hard to imagine fund managers simply ignoring these circumstances and failing to re-price securities to reflect the changes.
Left unchecked, prolonged credit expansion could create some of the conditions (such as high capacity utilisation rates, labour shortages and falling productivity) that support higher inflation. At some point, central banks might have to act to slow a recovery or, possibly, bring it to a halt through higher interest rates and restrictions on further credit expansion.
Between that happening and now, however, significant wealth creating opportunities will arise. Ignoring the links in the chain may lead those most fearful about inflation to be right in their prognosis but unable to take maximum advantage of their economic insights because they have run too far ahead of the pack too quickly.
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