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The next headline – Inflation.

Last summer consumers, businesses and investors faced inflation. Oil was on its way to $150. Higher transportation costs were impacting food prices (apples cost $1 each) and the inflation measure (the Consumer Price Index) was above 3% for four months in a row. The cost of living was stretching the budget. Inflation like this had been seen only twice since the 1980’s.

Then other more important things like watching investment bankers implode, seeing economies come to a screeching halt and agonizing over a 30-50% stock market correction while trying to stay employed all took priority. As economies slow they demand less oil and fewer commodities and the price drops. Since last fall inflation has dropped by ½ and then by ½ again. Inflation isn’t headline news today.

But it will be.

Governments everywhere are borrowing and spending not millions, not billions, but rather trillions to help economies, banks, industries, former employees and homeowners regain some financial footing. Over $7,400 billion in the US alone. (To offer some perspective, Phillips Hager & North and Bianco research suggest the entire 2nd World War cost $3,600 billion in today’s inflation adjusted dollars).

Massive spending combined with (eventual) renewed borrowing in a low interest rate environment on top of less but ongoing demand for scarce resources from China and India will mean inflation. (Think 3-5 years out).

How can an investor prepare?

The majority of an investor’s portfolio return comes from asset allocation to stocks and bonds. In theory, stocks provide some inflation protection. Inflation is simply rising prices for goods and services and the corporations who sell them should see higher revenues. But stocks can be volatile. The investor needs bonds for stability. But bonds are adversely affected by inflation. So a portfolio will need more than an allocation to simple stocks and bonds.

Real assets can help because they tend to have inflation protection qualities. Real assets include commodities (oil, gold, copper … ie. Buy Canada), commercial real estate, infrastructure (bridges, toll roads, water treatment plants, airports) and real return bonds.

Because they tend to have a return pattern (some have a stable income component) that is not directly correlated to stocks and bond returns they help to diversify a portfolio.

It would be a mistake however to expect real assets to be a perfect inflation hedge because, according to Russell Investments data, their historical correlations to inflation are lower than one would hope.  It’s also a mistake to invest in real assets alone (they can be as or more volatile and less liquid than stocks or bonds). The benefit rather is how real assets can contribute to and complement a traditional balanced portfolio of stocks and bonds. And most real assets can be accessed with Exchange Traded Funds which offer low-cost, one-stop, instant exposure and diversification.

Originally published in the Business Fraser Valley news, June 2009.

Doug Cronk CFA, is Manager Investments for a Canadian Pension Fund.

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