Tuesday 03 February 2015 by William Arnold Trade opportunities

Hedge against inflation now while it’s cheap

In a low inflationary environment, it is easy to discount the value of protecting against future inflation. On the other hand, now is a good time to lock in an inflation hedge because the cost is low. If inflation takes off, prices will increase sharply.

While the risk of inflation may seem low at the moment, it is possible that the global experiment in Quantitative Easing (QE), or “printing money” in order to stave off deflation risks, could overshoot, resulting in excess inflation in the medium term.

The market’s benign expectations for Australian inflation have been reinforced by the most recent Consumer Price Index (CPI) data, which showed that consumer prices increased less than expected in the last three months of 2014 with a rise of 1.7% in the headline inflation rate. This was just below economists' expectations of a 1.8% rise year-on-year and a sharp slowdown from the 2.3% increase reported for the preceding quarter. However, underlying inflation, which strips out the effects of extreme price movements at either end of the scale, actually came in stronger than economists were expecting, rising 0.7% in the December quarter for an annual rate of 2.25%.

So what about inflation in the longer term? The European Central Bank (ECB) and Bank of Japan (BoJ) are both using QE specifically to battle deflation, so there is a risk of them “over-succeeding” and creating global inflation.

Beyond 2015, there is a risk of inflation breaking out in Australia, compliments of the global QE experiment and impact of the falling AUD on import prices. The reality of QE is that it is an experiment. Economic theory, for what that is worth, tells us that adding liquidity to the economy or “printing money” increases inflation, as seen in Germany in the 1930s. Both the ECB and BoJ are attempting to increase inflation to stave off deflation risks. What if they succeed and global inflation spikes?

Inflation is an important consideration when assessing investment options, with the real return (or return after inflation) of most relevance to investors. Figure 1 below illustrates the effect of inflation on $100,000 of capital for investors who retired at decade intervals between 1960 and 2000 (calculated with the rates of inflation during those times). For example, a person who retired in 2000 would find the value of $100,000 of principal would now be worth about $60,000 in real terms.

retirement capital decay
Figure 1
Source: FIIG Securities

Looking ahead, the market is forecasting and pricing in inflation of less than 2% p.a. on average until 2020 (see Figure 2). Therefore, currently it is very cheap to buy inflation protection. Investors may wish to take this opportunity to protect against the threat of an inflation outbreak driven by central banks’ QE experiment. You can do this by buying inflation linked bonds while the market is pricing these securities cheaply.



historical break even inflation
Figure 2

There are a range of inflation linked bonds (ILBs), both capital indexed and annuity style. Below is an example of some ILBs in order of highest to lowest yield. Please note that these are indicative offers only. Please contact your FIIG dealer for more information.

inflation linked bonds table

Disclaimer

The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or  distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.

No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.

FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not provide tax advice and is not a registered tax agent or tax (financial) advisor, nor are any of FIIG’s staff or authorised representatives. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg.

An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.