Thursday, 16 February 2012

Investing History Lessons on Inflation Protection and Market Mood Swings

Which investments protect best against inflation or its opposite, deflation? Does it make a difference whether inflation is lowish, say the Canadian government's target 2%, or very high at 8% or more, such as during the 1970s?

The renowned Credit Suisse Global Investment Returns Yearbook is now out in the 2012 edition (download here) and its principal authors Elroy Dimson, Paul Marsh and Mike Staunton have taken a look at the issue. Their research is uniquely valuable in two ways: first, they cover a very long time period, all the way back to 1900, so that world wars and the Great Depression are factored in; second, they include data for 19 countries, giving a much broader range of economic pasts and therefore possible futures than only Canada or the USA can provide.

What the Yearbook tells us is that each of bonds, equities, gold, home ownership have a different protection role and reaction to inflation.

Bonds provide protection against deflation (falling prices). Examine the graph below from the Yearbook, showing real / after-inflation returns. In periods when there is significant deflation (more than 3.5% drop in prices), bonds do extremely well, better by far than equities. On the other hand, when inflation gets to 8% or more (anyone remember the 1970s?) bonds get hammered. Disinflation - a decline in inflation rates - also benefits bonds.

Equities do quite well during deflation and up to a point of modest inflation, with real returns of 10 to 12%. However, equities offer limited inflation protection as returns tail off significantly even at what may seem to be modest inflation levels of 3+%. At hyper-inflation levels, equities char like toast. Equities are especially susceptible to sharp jumps in inflation. The main reason to buy equities pertains to the expectation, as established by the long history presented in the Yearbook, that equities will provide greater long term returns over bonds, the so-called equity risk premium.

Gold enters the picture as a possible investment to hedge against high inflation but it has been subject to very wide fluctuations in value that have nothing to do with inflation. In addition, its return is very low - 1% or so - but this may only happen over decades as its price may be underwater for many years and in the meantime it produces no income per se. In the short term, gold's returns do not respond directly and go up with inflation.

Inflation-linked bonds (known as real return bonds in Canada) explicitly protect against inflation through clauses that automatically ratchet up their value with inflation. The problem right now is that yields are minuscule (the Bank of Canada sample bond page shows a real yield average around 0.5% for long term RRBs) or negative in the USA, Britain and Canada. It's protection but that's all.

Commercial real estate, despite its tangible nature, as the authors say " ... is not an investment that should be initiated because of a new concern about inflation risk". The authors conclude that its value is for long term investment returns and diversification.

House prices do not reliably move in tandem with inflation though they seem to keep pace with inflation over the long term with real returns around 1%. There is also much variation amongst the few countries (Canada isn't included) for which much data exists. Furthermore, an individual person's house is not diversified in the manner of the aggregate index data the authors have used, which makes a house a riskier investment. A house is mostly a place to live - a consumption good - and much less so an investment.

Other assets like infrastructure, energy, utilities, timber and private equity they say simply lack data to show any reliable conclusion about inflation protection capability.

Investor Lessons
  • diversifying a portfolio across both bonds and equities is an essential strategy to protect against the range of environments from deflation to high inflation
  • inflation-linked bonds offer solid inflation protection but at the moment that's their only value as returns are close to zero
  • gold may be good inflation protection but you might have to wait decades
  • a house is mainly a home, not an investment

Risk appetite - the alternation of panic and euphoria
Greed and panic are said to motivate investors in a ceaseless ebb and flow. Anyone reading financial media constantly sees mention of investor skittishness or confidence. But how to measure the mood? Credit Suisse have taken a shot at quantifying the "market mood" with its Global Risk Appetite Index (GRAI), which the Yearbook illustrates with a fascinating chart, reproduced below. The basics of the Credit Suisse method, described further in the Yearbook, is to "... track the change in the relative performance of safe assets versus more volatile assets, e.g. government bonds and equities".

Investor lessons
The Yearbook's charts and discussion of GRAI give rise to several lessons for the investor:
  • wild swings from euphoria to panic or vice versa are a feature of the investing landscape and reversals often take place very rapidly; unexpected events are constantly happening. The investor should steel him/herself to this reality to help resist getting caught up in rash reactive sells, or buys, driven purely by emotion.
  • risk appetite is not just investors' imaginations at work; it is related to changing economic reality but more often than not it overshoots that reality by an excess of optimism or pessimism. At the moment, the GRAI is at a low ebb and is just recovering from its lowest recorded levels with a huge gap between risk appetite and actual industrial production momentum. Perhaps this indicates an investor buying opportunity in general or for specific companies. Back in August, when GRAI entered the panic phase, we posted our opinion that there appeared to be a summer sale on many companies. Get 'em while the bargains last?
  • no indicator is infallible and the Yearbook cautions against simplistic application to buy-sell decisions; sometimes the GRAI reflects what is only a short-term blip while at other times it shows when major market reversals are starting. Use other tools like fundamental analysis of individual companies (see our post here) or overall market valuation (see our post here). Warren Buffett, that most successful of investors, puts it well: "If past history was all there was to the game, the richest people would be librarians." (quote from Brainyquote) The Yearbook's review of GRAI is unfortunately a one-time glimpse since GRAI is a proprietary product restricted to Credit Suisse clients who pay for on-going access. The publicly-available poor man's version for panic vs greed is the VIX, the CBOE Market Volatility Index (Wikipedia description here, Yahoo quote here).

George Santayana once wrote (quoted in Wikiquotes): "Progress, far from consisting in change, depends on retentiveness. ... Those who cannot remember the past are condemned to repeat it." What we aim to do as investors is to learn to retain the bits that work and avoid the bits that do not. Let us remember the past.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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