Inflationary
fears have been an intrinsic part of this summer’s investment
narrative, with price increases across both the developed and developing
economies. At a time when many advanced economies have almost ground to
a halt, many investors are mesmerised by growth stories in emerging
markets. But how much of the growth is eaten up by high inflation, and
how should investors protect their clients’ wealth?

At the beginning of August, a survey by UK-based Baring Asset Management
showed that more than three quarters of investors were worried about
the impact of inflation on their cash investments. Nine out of ten of
investors who took part in the survey said that their clients have
already or plan to reallocate cash investment to inflation-protected
assets.

“In terms of debt and indeed all investment, when you make your
long-term asset allocation, I would say that inflation is the biggest
consideration because over time it erodes the buying power of income,” Andrew Herberts, investment director and in charge of the investment strategies at Adam & Co, the UK private bank, told Wealthbriefing.

Some investors are stocking up on gold as a bulwark and the price of
the precious metal climbed over $1,900 an ounce on Monday, representing
an increase of 15 per cent this month. Other firms have highlighted
inflation-resistant stocks. For example, experts from Fidelity International last
month presented a selection of companies with enough pricing power to
thrive in the inflationary environment, including tobacco company
Swedish Match and luxury brand Burberry.

“It’s always good to have diversified assets, metals included,” Scott Patten, chief operating officer and partner at AU & Associates,
a New York-based family office, told this publication. “For us in the
US it makes sense to hold gold, because the US dollar is in decline and
we believe it will continue to decline in the future.”

Multinationals and oil

Equities are often seen as the best way to hedge against inflation in
the long term. “Some domestic large cap stocks offer good yield of
about 4 to 6 per cent, which works as a cushion but also provides good
growth potential,” Patten said. “The euro and the dollar have slid to
some degree, which means that multinational offers good opportunities at
the moment.”

Patten also singled out Oil Master Limited Partnerships as an
attractive investment in the US, as the price of oil has taken a 20 per
cent hit and energy demand continues to grow. Moreover, he emphasised
high yields and favourable tax treatments, and the fact that there are
very few alternatives to oil.

“In this environment, no fixed income is going to serve you
brilliantly,” Herberts said. “We do have some emerging market debt, and
it still gives you a better yield than developed market debt. South
Korea is one example that offers attractive government bonds. We’re
trying to avoid the likes of China and India.”

July’s consumer price index in South Korea was 4.7 per cent, up from
4.4 per cent in June. Core inflation, which excludes volatile items such
as energy and food products, stood at 3.8 per cent.

Safe havens in the developing world

There are those who are still keen on emerging market debt: “We
remain constructive and positive about local bonds in emerging markets,”Thanasis Petronikolos, head of emerging market debt at Barings, told Wealthbriefing.
“It is true that we so far this year have seen increasing inflation,
but it is mainly due to a rise in food prices which causes high headline
inflation. Core inflation has been much lower. For example, in China
headline inflation is 6.5 per cent but only 2.9 per cent when food
prices are excluded.

“We believe that inflationary pressures are weakening and that China
will fall below 5 per cent by the end of the year. Brazil, which has 6.9
per cent, will fall towards 6 per cent by the end of the year. It is
still quite high but it is falling and it will continue to fall in 2012,
as the world economy is slowing down, but also because interest rates
are at 12.5 per cent in Brazil.

“In Latin America, inflationary pressures have been subdued. I would
recommend Mexican bonds, but not just for that reason. They have been
one of our overweight positions and performed well in the last month.”

Mexico’s latest CPI reading stood at of 3.3 per cent, according to
the central bank, marginally lower than a year ago. The producer price
index, which some argue is a more relevant way of measuring inflation,
was 3.55 per cent.

“In Eastern Europe, inflationary pressures are modest in Hungary and
it has one of the best inflationary outlooks in the region. First,
because of what’s happening in Europe, but also because interests are
quite high (6 per cent).”

In Hungary, the annual CPI rate of 3.1 per cent in July was lower
than 3.5 per in the previous month and close to the central bank’s
target of 3 per cent.

“In Asia, I would look at Malaysia and Taiwan. Many Asian currencies
are undervalued and they have the option to appreciate, which is another
way to control inflation and another argument in favour of local
bonds,” he said.

Malaysia had a headline inflation rate of 3.5 per cent in June,
according to the central bank. In Taiwan, the rate slowed from 1.9 per
in June cent to 1.3 per in July.

Not the biggest threat on the radar

Petronikolos concluded that Barings is not concerned about inflation
and that his team sees a greater risk on the growth side. However, he
emphasised that investors who are concerned have the option to buy
inflation-linked bonds. “In that case, I would recommend buying
inflation-linked bonds in Turkey and Poland, because they are better
priced than the ones in Latin America,” he said. “We do have some
inflation-linked bonds, but not many because they don’t offer attractive
entry-points.”

“Inflation-linked bonds are a compelling place to be at the right
price and the right time, like in 2009,” Herberts said. “Under the right
circumstances, they offer proper protection against inflation. But they
are expensive at the moment; most fixed income is fairly fully valued.”

Most experts believe that we will see waning inflationary pressures
across the board next year, as the world economy is slowing and demand
will ease off. Ben May, European economist at Capital Economics, a
macro-economic research consultancy, pointed out that some of the
countries that are now boosting low inflation in Europe, such as Sweden
and Switzerland, might see higher rates in the next couple of years. “We expect
eurozone CPI inflation to average around 1.5 per cent next year and 0.5
per cent in 2013,” he said. “Unless their currencies continue to
appreciate sharply, stronger economic recoveries in Sweden and
Switzerland mean that inflation in both economies may be higher than in
the eurozone in 2013.”

“High inflation has been part of the story so far this year; over the
next two years, we believe that growth will be a much bigger concern,”
Neil Shearing, emerging market economist at Capital Economics, told this
publication. “If you ask investors if they are worried about inflation
next month, I think you will get a very different story.”