Threat of inflation on hold ... for now

25/06/2009 - 00:00

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INFLATION is dead and buried and there is presently more concern among bankers about a continuation of falling prices than a return to the hyper-inflation conditions of the 1970s.

Threat of inflation on hold ... for now

INFLATION is dead and buried and there is presently more concern among bankers about a continuation of falling prices than a return to the hyper-inflation conditions of the 1970s.

So it is surprising, given the level of damage inflicted on global economies by the 21st century's credit bust that many folks are indeed beginning to fear a new round of inflation is lurking somewhere in the wings.

Following the near financial meltdown experienced late in 2008, financial markets have had time to take a breath and survey the damage. Prices for almost everything have plummeted as over geared individuals and companies have become forced sellers of all types of assets.

Despite a recovery since March, most commodities are trading at or below 50 per cent of their 2007-8 peaks. Interest rates have fallen which, combined with falling house prices, has reduced the cost of accommodation while a halving of the oil price is flowing through to lower transport and fertiliser costs, feeding into everything from food production to the cost of plastics and logistics support. Under these conditions, why would anyone fear inflation right now?

Governments in the US and Europe have rushed to 'save' financial institutions by injecting billions of taxpayers' dollars into new equity and by providing government guarantees for bank deposits and debts. This behaviour is most prominent in the US, where the government has ended up owning a large chunk of some moribund financial intermediaries and industrial dinosaurs, such as General Motors.

Additional liquidity has also been pumped into markets around the world by government spending, designed to stimulate economic activity. Central banks from Washington and London to Canberra and Beijing have been busy creating money in a process called 'quantitative easing'. All this newly minted cash is leaving a huge legacy of latent inflation in many economies and wise heads are rightly worried.

In the short to medium term, interest rates appear to have bottomed out and have indeed begun to rise locally. Rising interest rates threaten the global stock market rally and will cause some turbulence along the way, but should not terminate a longer-term recovery as most stock market bull runs are indeed accompanied by gently rising interest rates.

Look out to the end of 2010, when economic activity should be picking up; there is every reason to believe that commodity prices, including the all-important oil, will begin to rise, lifting inflation.

In 2006, there was a worldwide scarcity in some commodities - iron ore, coal, oil, rice, corn and others were is such short supply that prices skyrocketed and the market was strained on many occasions.

Food importing nations such as Egypt, China and the Gulf States were alarmed to find that they could not import certain foods at any price during 2007-8. The market for rice broke down and it was simply not available. Money is now beginning to move out of Brazil, Russia, India and China into coveted agricultural and other assets in North America, Europe and Australia.

Saudi Arabia is a large food importer and was alarmed at this turn of events. So it is no surprise to see Saudi poultry producer, IFFCO, turn up with 19.99 per cent of Australian farming company Australian Agricultural Company (AACo). AACo's pastoral holdings cover the equivalent of 1 per cent of Australia's landmass; it runs about 600,000 head of cattle as well as producing significant quantities of grain for animal feed.

Inflation will certainly return by 2011, as markets strain to supply the world's 6.8 billion people with the commodities they demand.

In the US, the government will be doubly cautious about rising interest rates, since this would not only be inflationary, but also lift funding costs for the substantial amounts of debt that it has and continues to take onboard. Many observes are wondering if the US government will just let the dollar fall, which would be inflationary as well, but would allow the government to maintain its funding position, while allowing the debt to reduce in value as a result of falling currency and rising inflation.

At the heart of this debate is the knowledge that when you increase money supply at a rate well in excess of the rate of growth in other asset classes, the value of money will decline as it pushes up prices of so-called hard assets. Too much money in the system, as a result of government over-borrowing and over-spending, will reduce the value of money and raise prices - that is, cause inflation. It's the Zimbabwean scenario.

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Savings rates in the US have risen from -2.7 per cent in late 2006 to around 5.7 per cent today and look like rising towards 9 per cent. Sooner or later, savers around the world will look at the returns they can earn on cash and decide that their wealth would be better held in other asset classes, such as equities or property.

The Chinese government has already decided that it would rather hold copper than US dollars, and that trend of converting cash into hard assets will continue, especially as more central bankers begin to doubt the wisdom of holding greenbacks.

To a large extent, the impact of declining asset prices, caused by fallout from the credit crisis, has offset the inflationary impact of this additional cash, but recent stability in asset prices and stronger equity markets exposes potential for an inflationary outcome at some point in the not-too-distant future.

Briefcase believes that, in the longer term, the wall of cash now being saved by individuals and companies will begin to descend on real assets, driving up their prices and creating the mother of all inflationary booms, probably in 2011.

A USD currency crisis later in 2009 could hasten this flight from USD into other currencies as well as other asset classes. Once inflation takes hold, the last thing you want to own is cash, which is devalued by inflation. Only real or hard assets hold their value through a bout of inflation.

Briefcase favours gold as an inflation hedge, which can be held as bullion, or as shares in producers such as Avoca Minerals or developing producers such as Integra or Alkane. Another avenue is to own shares in companies that hold real assets, such as commercial or industrial property and infrastructure assets, whose revenue is linked to inflation, or energy assets and mining companies as well as mining service companies.

Examples of stocks in these areas include BHP Billiton, which is not only a major base metal, iron ore and coal miner but also has a significant oil and gas presence, providing a natural hedge against rising fuel prices.

Utilities include Origin Energy, AGL and Telstra, while energy stocks of interest include Oil Search, Woodside and Arrow Energy. Listed property companies are all very cheap, but care should be taken to choose only companies that have exposure to Australian industrial or commercial property and not those holding residential or US property of any size. The best local example is Bunnings Warehouse. Service companies include Transfield, Worleyparsons, Neptune Marine, Imdex and Mermaid Marine.

In the very short term, bonds and cash may still be a reasonable place to hold wealth, but during 2010 Briefcase believes that it will be time to make sure that you are holding assets that will not be negatively affected by monetary inflation.

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n Peter Strachan is the author of subscription-based analyst brief StockAnalysis. Further information can be found at Stockanalysis.com.au.

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