Inflation first aid: Gold, oil and real estate

Inflation first aid: Gold, oil and real estate
By ROB CARRICK Globe and Mail Update
The arch-enemy of all investors is threatening a comeback after a long time away.

Inflation hasn't been a top-of-mind consideration for investors since the early 1990s, and today it's hardly noticeable. But there's growing concern that soaring prices for oil and food products are within the next year or so going to push the inflation rate higher than we've seen it in years.

This edition of the Portfolio Strategy column is all about inflation-proofing your portfolio, which is more problematic than you may think. Some investors automatically look to real-return bonds if inflation's a threat, but there are good reasons to avoid them. Gold and commodities are classic inflation defences, but neither is any sort of a bargain right now.

The first thing you need to understand about inflation is that it's a global phenomenon, even if the cost of living here in Canada in March was just 1.4 per cent ahead of where it was a year earlier. The inflation rate in the United States in March was 4 per cent, and other regions are comparable or worse.

“In Europe, inflation is running over 3 per cent, and in the emerging markets it's on fire,” said Alec Young, an equity market strategist with Standard & Poor's in New York. “In Russia, you've got 12 per cent and you've got 8 per cent in China. It's accelerating.”

Expect the usual carnage if inflation flares up here. The bond market will be hammered as interest rates rise, and the stock markets will struggle. The trouble for stocks arises from the fact that inflation makes investors more conservative about what they're willing to pay for a company's shares. Price-earnings ratios tend to fall, and that means lower share prices.

The market sectors that buck this trend are the ones that are based on gold and commodities such as oil and gas, metals and fertilizer. The psychology here is that commodities are hard assets that hold their value when prices are rising.

When the inflation rate surged into double digits in the 1970s, commodities were the place to be. The problem with commodities today is that they've already experienced a gigantic runup in price. In fact, rising oil and fertilizer prices are key reasons why inflation is globally on the rise. The price of crude oil, for example, has jumped about 75 per cent in the past year to its current range of around $116.

“Traditional inflation hedges don't look like attractive bargains right now, so the past may not be prologue this time around,” Christopher Davis, an analyst with the Chicago-based research firm Morningstar, wrote in a commentary this week.

Mr. Davis suggested a dollar-cost-averaging approach for getting into commodities, where you make small, regular purchases every month or quarter. That way, you get to take advantage of the sort of pullbacks we saw this week in oil and gold prices. Long term, there are commodity price forecasts out there that make a case for buying at current levels. Last month, CIBC World Markets issued a widely quoted forecast that crude oil prices would rise to $200 (U.S.) a barrel over the next five years, and that gasoline prices would jump to $2.50 (Canadian) a litre.

Be prudent when adding commodity exposure to your portfolio. Many Canadian investors already have substantial exposure to oil, metals and gold through their mainstream equity funds, exchange-traded funds and individual stocks. Both sectors together accounted for 47.8 per cent of the S&P/TSX composite index as of March 31.

Gold is the classic inflation hedge because of its intrinsic value, but S&P metals analyst Leo Larkin believes the price is heading lower in the months ahead. The price of gold surged 32 per cent last year and another 23 per cent in early 2008 to a peak of $1,030 (U.S.). It has since fallen to the $855 range, and Mr. Larkin said it's possible it might decline to $730 at worst.

From there, Mr. Larkin expects gold to head sideways for six months or so before mounting a comeback that could see it revisit the highs of earlier this year. “If inflation is kicking up, I don't see why ultimately it wouldn't surpass the old highs maybe some time in mid-2009.”

An inflation-resistant sector you can buy into now at cut-rate prices is commercial real estate, which is mainly represented in the stock markets by real estate investment trusts. Recent financial market volatility has made investors leery of REITs on a global basis, and concerns about slower economic growth are a problem as well.

Here in Canada, the S&P/TSX capped REIT index is off about 18 per cent over the past 12 months. However, CIBC World Markets issued a report earlier this month saying the selloff of Canadian REITS belies some strong underlying fundamentals such as low vacancy rates and only a trickle of new properties hitting the market this year and next.

While the stock markets are averse to inflation, bonds are strongly allergic. Rising prices will goad central banks into increasing interest rates, and that always sends bond prices lower. Your best bet, says BMO Nesbitt Burns fixed income strategist Michael Herring, is to invest in short-term bonds. They'll hold up better than long-term bonds in a rising-rate environment.

The obvious bond choice for the year ahead would seem to be real-return bonds, which adjust their semi-annual interest payments and the amount you receive on maturity to account for higher inflation. But Mr. Herring advises against real-return bonds because they're a suspect value based on current prices. “My point of view is that people are overpaying for the inflation insurance that real-return bonds give you.”

Another thumbs-down for real-return bonds comes from Sheldon Dong, fixed income strategist at TD Waterhouse. He doesn't recommend them for retail investors because they behave like long-term bonds and thus have a tendency to be disturbingly volatile on a month-to-month basis.

“I've never been a big proponent on these things,” Mr. Dong said. “Most people own stocks, and most people own oil. That's their inflation protection right there.”
©
© Copyright CTVglobemedia Publishing Inc. All Rights Reserved