Are Inflation Fears Overblown?


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Many investors—especially those who remember the
recessions and stagflation (high inflation and low
economic growth) of the mid-1970s—grow uneasy at
the prospect of a new cycle of inflation and what it
may mean for their investments. And telltale signs like
higher oil and food prices, gold reaching new price
plateaus, unprecedented new deficit spending by the
federal government and an expansive monetary policy
suggest there may at some point be cause for concern.

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Are Inflation Fears Overblown?

  1. 1. ab Market outlook Are inflation fears overblown? Market outlook is a monthly publication to help inform your investment strategy July 2009 Many investors—especially those who remember the readily be met by rising output, rising demand will translate recessions and stagflation (high inflation and low into inflation, although WMR doesn’t see the U.S. operating at economic growth) of the mid-1970s—grow uneasy at full potential until the end of 2010 at the earliest. the prospect of a new cycle of inflation and what it may mean for their investments. And telltale signs like So what are investors to do right now? While there is no higher oil and food prices, gold reaching new price perfect hedge against inflation, it would be prudent to plateaus, unprecedented new deficit spending by the begin thinking about what impact inflation may have on federal government and an expansive monetary policy their portfolios. It would be best to steer clear of certain suggest there may at some point be cause for concern. investments and consider implementing others that could help protect against and even potentially profit from To combat the financial and liquidity crises, the Fed took structurally higher inflation in the long term. action, starting about a year and a half ago, cutting interest rates to near zero and engaging in what is called credit Floating-rate securities easing, which is essentially the printing of new money and Central banks like the Fed typically hike interest rates swapping it for longer-term financial assets. Sufficiently when they anticipate rising inflation. And higher interest aggressive easing should flood the economy with new rates usually have negative consequences for fixed income money, increase spending and support or even lift prices. Yet investments; already-issued ordinary bonds with fixed if easing is too successful, undesirably high inflation could be coupons decline in value, since investors can receive a higher generated over the medium to longer term. interest rate in the market compared to their bonds’ fixed coupons. In contrast to fixed-rate bonds, however, investors Another potential complication involves timing. While UBS may wish to consider bonds with interest rates that are reset Wealth Management Research (WMR) thinks the Fed’s with changes in an underlying rate or index. (See chart on measures will eventually succeed in pulling the U.S. economy the next page.) For example, CPI-linked bonds such as U.S. out of recession, once that takes place, the problem will Treasury Inflation-Protected Securities (TIPS) will be reset with switch from growth weakness to rising inflation. The Fed changes in the Consumer Price Index. Floating rate notes must correctly time the move from expansive to restrictive (FRNs) issued by corporations will typically have their coupon monetary policy in an effort to mop up the excess liquidity rates reset based on changes in the interest rate environment, that was pumped into the economy, or the flood of fresh which may or may not be in line with actual inflation. money could find its way into consumer or asset prices, resulting in rising inflation. Foreign exchange Inflation can do long-term damage to a currency. The law of WMR believes inflation will likely be on average higher than one price, or purchasing power parity (PPP), says the inflation the 3% we’ve seen over the past 25 years. Once the economy differential between countries must be compensated for with operates at full potential again and additional demand can’t a devaluation of the currency with the higher inflation. In
  2. 2. Commodities Inflation expectations in the U.S. A sharp increase in U.S. liquidity has historically often produced in %, calculated as the difference between yield a lagged price rally in commodities. Commodity markets with on nominal and real inflation-linked bonds low spare capacity and high cyclical exposure—like oil, copper, lead and tin—should do relatively well once demand recovers on a broad scale and old supply constraints resurface. Even so, WMR believes inflation alone is not a sufficient reason to buy commodities, with the exception of certain precious metals. The high industrial demand for platinum and palladium means prices are sensitive to and fluctuate strongly with economic swings. With gold, however, industrial demand is quite low, around 20%, so it is less reactive to economic swings and well suited to be an inflation hedge, says WMR. The price is expected to test all-time highs, reaching $1,100 in the third quarter of 2009, thanks to an onset of inflationary pressures in the U.S., renewed U.S. dollar weakness and greater jewelry demand in the second half of 2009, as retailers are forced to restock their depleted inventories. Real estate During periods of high inflation, real estate prices have historically generated a big increase in returns and largely practice, this devaluation can take time, sometimes years. preserved the purchasing power of the money initially There are even cases where inflation weakens rather than invested. WMR says real estate as a direct investment should promotes appreciation pressure. In the U.S., the Fed has still offer the best hedge against inflation in the long run, embarked on credit easing which might lead to inflation yet real estate equities and REITs perform similarly to normal and a weakening effect on the dollar. Also, the market equity markets, exposing investors to other, sometimes more is likely to demand a higher risk premium for holding the important, price drivers. Real estate funds appear to have currency. WMR says investors should avoid probable high- some inflation-hedging characteristics as they are generally inflation currencies of the U.S. and the U.K., as they will likely more exposed to residential properties. Still, WMR cautions depreciate in value over time and increase their positions in that the real estate sector is likely to remain in the doldrums Asian countries, which appear attractive from their growth for the foreseeable future and expectations of high inflation and inflation perspectives. should not be the sole driver behind a real estate investment. Equities For more information Over the short term (less than a year), there’s generally a To explore how some of the insights in this issue of Market negative correlation between stock market returns and Outlook might bear on your portfolio, please contact your inflation. According to WMR, stocks are only effective hedges Financial Advisor. For more detailed information on the above against inflation if the investor has a short position. For the article, please ask your Financial Advisor for copies of the long run (over five years), however, the correlation is usually following Wealth Management Research reports: Investment positive. Overheating economic activity is typically followed by Themes, “Long-term strategies to meet a surge in inflation,” rising inflation, which coincides with stock market corrections, June 25, 2009, and “Lower EM inflation now, but risks as valuations become elevated and market participants start loom,” June 22, 2009; Commodity Report, “Don’t get too to anticipate a cyclical slowdown in growth. Investors are negative on gold,” June 18, 2009; and the Economic Theme, mainly concerned about the long-term consequences of losing QE3: The longer-term implications,” June 4, 2009. real wealth by structurally higher inflation rates, rather than short-term cyclical swings, and WMR emphasizes the positive, long-term relationship between stock returns and inflation. There are two sources of UBS research. Reports from the first source, UBS Wealth Management Research (“WMR”), are produced by UBS Wealth Management Americas (the UBS business group that includes, among others, UBS Financial Services Inc. and UBS International Inc.), and UBS Wealth Management & Swiss Bank. The WMR report style, length and content are designed to be more easily understood by individual investors. The second source of research is UBS Investment Research, and its reports are produced by UBS Investment Bank, whose primary business focus is institutional investors. The research reports may include estimates and forecasts. A forecast is just one element of an overall report. Due to a divergence of opinions, there may sometimes be differences between the individual and institutional reports, with respect to interest rate or exchange rate forecasts. The analysts who prepare individual and institutional research use their own methodologies and assumptions to make their independent forecasts. Neither the institutional forecast nor the individual forecast is necessarily more reliable than the other. The various research content provided does not take into account the unique investment objectives, financial situation or particular needs of any specific individual investor. If you have any questions, please consult your Financial Advisor. UBS Financial Services Inc. is a subsidiary of UBS AG and an affiliate of UBS International Inc. In Canada, UBS Wealth Management Research is provided by UBS Investment Management Canada Inc. All other trademarks, registered trademarks, service marks and registered service marks are of their respective companies.. UBS Financial Services Inc. and UBS International Inc. are subsidiaries of UBS AG. ©2009 UBS Financial Services Inc. All rights reserved. Member SIPC. MOC_July2009