Inflation   Why To Worry Or Not
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Inflation Why To Worry Or Not

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A presentation I did on how to protect portfolios against inflation

A presentation I did on how to protect portfolios against inflation

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Inflation   Why To Worry Or Not Inflation Why To Worry Or Not Presentation Transcript

  • Deutsche BankPrivate Wealth Management Inflation: Why Worry, Why Not to Worry, and What to do if You‘re Worried Marshall Gittler Chief Strategist, EMEA Place des Bergues 3 CH-1211 Geneve 1 Switzerland marshall.gittler@db.com +41 (0) 22 739 0463 May, 2011
  • Inflation: Why Worry Central banks‘ real policy rates at or below zero Hyperinflation Deflation — Central banks around the world sharply reduced their policy rates in response to the 2008 financial crisis, in many cases to zero. After taking inflation into account, the real policy rate is at or below zero in most regions except for Latin America.Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 2
  • Inflation: Why Worry Major central banks expand their balance sheets Hyperinflation Deflation — In addition to reducing the price of money, central banks have been aggressively increasing the quantity of money available by pumping up their balance sheets. This increases the supply of reserves that banks hold, which eventually should increase the amount of bank loans and hence the supply of money.Source: Bloomberg Financial LP, Bank of Japan, Bank of England, Swiss National Bank, Deutsche Bank Global Investment Solutions Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 3
  • Inflation: Why Worry Narrow money supply is rising, broad money just starting Hyperinflation Deflation— The growth in narrow monetary aggregates, which the central banks control, came down sharply after its 2009 spike, but has started to recover again.— The broad aggregates – which the market controls – have also been recovering since the beginning of last year, but are still well behaved. Large-scale inflation is not likely unless these broader aggregates start to rise sharply as well.Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 4
  • Inflation: Why Worry Narrow money supply is rising, broad money just starting Monetary base and M2 in the US and Eurozone— We can see this difference particularly in the US and in Europe. The monetary base (MB), which consists of banks‘ reserves at the central bank and cash in the hands of the public, has soared because of the extraordinary ―quantitative easing‖ in which central banks buy bonds from the market, However growth in the broader aggregates, which represent money available for spending, is still relatively tame.— In the US, M2 is defined as M0 (bank reserves at the central bank plus notes and coins in circulation) plus deposits in checking accounts (M1) plus money in savings accounts, certificates of deposit up to $100k, and money market accounts. In Europe, the European Central Bank defines M2 as M0 plus overnight deposits, deposits with maturities of up to two years, and deposits redeemable with notice of up to three months.Source: Fed, ECB, Deutsche Bank Global Markets Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 5
  • Inflation: Why Worry Inflation has followed broad money growth in USBroad money growth and inflation over time in the US Hyperinflation Deflation— What would happen if broader monetary aggregates start to rise more rapidly? The relationship between the rate of growth in broad money and the rate of inflation in the US is well established over long time horizons. Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 6
  • Inflation: Why Worry The same relationship holds across countriesBroad money growth vs inflation in several countries Hyperinflation Deflation— This relationship is not unique to the US. It also holds in a wide variety of countries. Source: iMF, OECD, Deutsche Bank Global Markets Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 7
  • Inflation: Why Worry Inflation is also a fiscal phenomenon, not just monetary US and UK inflation, 1750~present Hyperinflation Deflation 15 Fiscal monetisation Volcker Consumer price inflation (% yoy, 11 year ma) during WWI clamps Fiscal monetisation down on 10 Napoleonic wars: US UK during WWII inflation US war of deficit monetised US civil war independence 5 0 Fiscal monetisation -5 during Vietnam War; 1st industrial revolution: 2nd industrial revolution: oil shocks productivity-led deflation productivity rebound; Depression -10 gold finds 1750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000— Inflation is not just a monetary phenomenon. Historically, when governments have run up big debts (usually due to wars), they have resorted to inflation in order to diminish the burden of paying back that debt.Source: Deutsche Bank Global Markets Research Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 8
  • Inflation: Why Worry How debt/GDP ratios have been reduced in the past1. Economic growth2. Substantive fiscal adjustment/austerity plans3. Explicit default or restructuring of debts4. A sudden surprise burst in inflation5. A steady dosage of financial repression that is accompanied by an equally steady dosage of inflation Source: C. Reinhart and M. Sbrancia, “The Liquidation of Government Debt,” Peterson Institute for International Economics WP 11-10 Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 9
  • Inflation: Why WorryFinancial repression and the US post-WWII debtThe US govt engineered negative real rates to reduce its debt — The US had significant debts left after WWII. Strong growth helped to reduce these debts, but financial repression also played its part. — Financial repression included: — Interest rate ceilings on deposits, which induced investors to hold govt bonds. — Regulations to ensure that govt debt played a dominant role in domestic institutions‘ asset holdings, particularly pension funds — High reserve requirements for banks — Restrictions on the international movement of capital and on gold holdings — Overall, low nominal interest rates (below nominal GDP growth) and inflationary spurts resulted in negative real interest ratesSource: C. Reinhart and M. Sbrancia, “The Liquidation of Government Debt,” Peterson Institute for International Economics WP 11-10Deutsche Bank Marshall GittlerPrivate Wealth Management 2011 Family Office & Wealth Management Conference 10
  • Inflation: Why Worry Inflation is politically easier than taxation Hyperinflation Only in taxation do people discern the Deflation arbitrary incursions of the state; the movement of prices, on the other hand, seems to them sometimes the outcome of traders’ sordid machinations, more often a dispensation which, like frost and hail, mankind must simply accept. The statesman’s opportunity lies in appreciating this mental disposition. Friedrich Bendixen, German economist and banker (1864~1920)Source: Robert Hetzel, “German Monetary History in the First Half of the Twentieth Century”Source for photo: Wikipedia Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 11
  • Inflation: Why Worry Fiat money makes it easier to create inflationUK price index through the ages (log scale) Hyperinflation Deflation think that modern — Don‘t central banking will prevent a reoccurrence of this phenomenon. On the contrary, modern central banking and the invention of fiat money (as opposed to money backed by precious metals( has made it easier for central banks to debase the currency. — If we look at Great Britain, prices rose 10x in the 600 years from 1300 to 1900. They rose 100x in the following century, and most of that has occurred just in the last 65 years since WWII. Source: SG Securities,, “Popular Delusions,” 27 May 2010 Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 12
  • Inflation: Why Worry Government monetization of debt causes hyperinflation Weimar inflation caused by soaring monetary base Argentina did the same more recently Notes: Data normalized with 1913 equal to 1. Observations are the natural logarithm. The monetary base is cash in circulation plus commercial bank deposits at the Reichsbank.— From the end of WWI to 1924, the price level in — Argentinian inflation, already running at 500% a year Germany rose by almost 1trn times. by 1989, soared to 20,000% by 1990 as the monetary base rose 12,726% a year at its peak in— In 1913, total currency in Germany was 6bn marks. early 1990. Ten years later, a loaf of bread cost 428bn marks.— The cause of this inflation was monetization of debt — Something that cost 1 cent in Jan 1988 cost $76 just by the central bank, the Reichsbank. four years later.Source: Robert Hetzel, “German Monetary History in the First Half of Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions the Twentieth Century” 13
  • Inflation: Why Worry Banking crises often result in inflation as well Inflation and external default 1900~2006— A banking crisis is typically followed by external default. External default is typically followed by inflation. Source: Reinhart and Rogoff, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” http://www.nber.org/papers/w13882.pdf?new_window=1 Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 14
  • Inflation: Why WorryWhat is the actual inflation rate?Government changes in calculation method reduce stated inflation rate — The US government has changed the way it calculates the inflation rate 24 times since 1978. — If it were still calculated the same way it was done in 1980, it would be closer to 10%. — Technological improvements help to hold down the rate of inflation, but you can‘t eat an iPad.Source: Courtesy of www.shadowstats.comDeutsche Bank Marshall GittlerPrivate Wealth Management 2011 Family Office & Wealth Management Conference 15
  • Inflation: Why Not to WorryEconomists are not looking for rapid inflation DB Global Markets model of inflation based on economists‘ forecasts— Economists are not looking for a major rise in inflation. A model of inflation that uses the year-ahead forecasts of inflation based on the Survey of Professional Forecasters suggests that inflation is likely to accelerate but remain below 2% next year in both the US and the Eurozone. Source: BLS, Eurostat,, Deutsche Bank Global MarketsDeutsche Bank Marshall GittlerPrivate Wealth Management 2011 Family Office & Wealth Management Conference 16
  • Inflation: Why Not to Worry Difference between then and now: the demand for money Rates soared in Argentina… …but have collapsed recently— As the money supply soared in Argentina, interest — This time around however interest rates have fallen rates soared too, with 1~2 month deposit rates even as central bank balance sheets have doubled. reaching 1,650% a year in 1989 (when inflation was 1,233%). — While the supply of money is soaring, the demand is collapsing. Thus the price is also falling.— The market broke down completely for a time in 1990 as inflation soared to over 20,000% a year.Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 17
  • Inflation: Why Not to Worry QE does not actually increase the supply of money The composition of the private sector‘s balance sheet changes, not its size Before Fed buys bonds from the market Bank ABC Fed Treasury Reserves 50 Deposits 100 T-bills 50 Reserves 50 Money 45 T-bills 50 Loans 20 Capital 10 T-bonds 0 Public goods 45 T-bonds 40 T-bonds 40 After Fed buys bonds from the market Bank ABC Fed Treasury Reserves 90 Deposits 100 T-bills 50 Reserves 90 Money 45 T-bills 50 Loans 20 Capital 10 T-bonds 40 Public goods 45 T-bonds 40 T-bonds 0— Quantitative easing does not cause any change in the size of the private sector‘s balance sheet, only the composition. It exchanges interest-bearing bonds for non-interest-bearing reserves. So in fact QE may be a net drain on the private sector‘s funds (in that it reduces interest income).— The Fed‘s balance sheet does expand, as does the composition. But it is not new money being injected into the private sector; it is merely being swapped for an asset that was previously created (and the money already spent by the government). So net financial assets do not change.— There is no effect on the Treasury‘s balance sheet.— The duration of the publicly held bond market is changed. Source: Deutsche Bank Global Investment Solutions Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 18
  • Inflation: Why Not to WorryWe expect only modest inflation in the developed world DB inflation forecasts— We expect inflation to remain under control in the developed economies. While it might rise slightly above the Fed‘s 2% target in 2011 and 2012, we expect this will be largely due to energy and commodities – underlying inflation should remain under control.— In the emerging market countries, we expect inflation to come down in Asia in the second half of the year and for inflation in all regions to be lower in 2012 than in 2011.Source: Deutsche Bank Global MarketsDeutsche Bank Marshall GittlerPrivate Wealth Management 2011 Family Office & Wealth Management Conference 19
  • Inflation: Why Not to WorryChinese inflation likely to slow in 2H Food inflation peaking Money supply growth has slowed— Rising inflation in China has been driven mostly by — Money supply growth has also come down sharply higher food prices. over the last several months under government— However, food prices have come down in the last pressure. few weeks, leading us to expect that inflation is — The lagged effect of these efforts should help to likely to peak in the next few months and fall in the bring down the rate of inflation as well. second half of the year. Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 20
  • Inflation: Why Worry Nonetheless, even low inflation has a big impact over time Value of money under various inflation regimes Hyperinflation Deflation — Nonetheless, it doesn‘t require hyperinflation to make a dent in the value of your portfolio over time. Even small levels of inflation will slowly eat away at the real value of your assets. — For example, with 1% inflation you effectively have only 90% of your money left after 10 years. If the inflation rate rises to 3% -- not that high, really – the amount would be reduced to 74% after 10 years. — And at that rate, after 50 years the real value of your assets would be worth only 22% of what they were at the beginning. The central bank would have taken 80% of your money away, bit by bit, without your hardly noticing it.Source: Deutsche Bank Global Investment Solutions Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 21
  • Inflation: What To Do About It if You‗re Worried Nature of the two types of inflation Correlation between growth and inflation Expected vs unexpected inflation — Growth and inflation are typically positively correlated. During such times, risky assets can — The main risk to a portfolio is from inflation perform well. shocks or ―unexpected inflation,‖ which can — However the correlation does not always hold. change‘ views on the relative merits of Sometimes there is stagflation, sometimes different asset classes and change discount inflation falls even as growth accelerates. rates. There is little correlation between expected and unexpected inflation.Source: Deutsche Bank Global Markets Research 22
  • Inflation: What To Do About It if You‗re Worried Impact on assets of an inflationary shock — According to an IMF study1, the response of different asset classes to inflation varies over time. This means that the optimum portfolio in response to rising inflation must be Inflation shock elasticities* rebalanced dynamically as the economy and markets adjust to the change. — By asset class, the results of the IMF study were: — Cash: Cash returns increase with inflation, but the response is gradual and less than complete. Over the long run, cash has not fully compensated for the increase in prices. That could be different in the future if central banks take a more active stance against inflation. — Bonds: Long-term bonds are the worst performing asset immediately following an inflation shock as yields increase. After about three years though, the dynamics gradually move in favor of long-term bonds as real yields rise. — Equities: Equities have not protected against inflation in the long run. Equity returns decline immediately after an inflation shock and do not recover meaningfully after that. This makes them the worst performing asset class over the long run in Years after the inflationary shock response to an inflationary shock. This is not to say that equities underperform other traditional asset classes in real *Defined as the percent change in the asset class total return or price index divided by the percent change in inflation. An inflationary shock is defined as a one standard deviation terms over long horizons, just that they may not offer much change in the month-on-month rate of inflation (0.2 percentage points). protection during periods of rising inflation. — Commodities: Commodities have been the best performing asset class when inflation was rising, but the long-term effects of inflation cause commodity prices to fall gradually,1Source: Roache, Shaun K. K. and Attie, Alexander P., Inflation Hedging for Long-Term Investors (April either because of rising real interest rates or slowing output.2009). IMF Working Papers, Vol. , pp. 1-37, 2009. Available at SSRN: http://ssrn.com/abstract=1394810 — This study did not include real estate or index-linked bonds. 23
  • Inflation: What To Do About It if You‗re Worried Equities are not as good an inflation hedge as believed Equities vs unexpected inflation: negative correlation Larger inflation shocks cause worse returns — A little bit of inflation can be good for equities. The price/earnings — Equities are not always a successful hedge ratio (P/E) in the US has generally been highest when inflation is against unexpected inflation. In fact, there is a 1%~2%, followed by 2%~3% (the range that we expect). negative correlation between unexpected inflation — But as inflation climbs, forward P/E ratios start to decline. This is and equities (i.e., the greater the unexpected because the company‘s real return on equity (ROE) falls as the replacement cost of its assets rises and accounting depreciation shock, the worse equities do. falls below replacement cost. Nominal returns rise, but real returns fall. The market sees through this problem and assigns a lower P/ESource: Deutsche Bank Global Markets Research. “Unexpected inflation” is defined as the difference ratio to stocks as inflation rises.between 1yr ahead US inflation forecasts from the Survey of Professional Forecasters with realized yoyinflation. — But a moderate rise in inflation – as we expect -- tends to cap the upside for stocks, rather than introducing any downside. 24
  • Inflation: What To Do About It if You‗re Worried Commodities have hedged against unexpected inflation Commodities vs unexpected inflation — The correlation between commodity returns and inflation has been positive, with high commodity returns associated with high unexpected inflation. — Of course, this correlation will hold when inflation shocks result from high commodity prices, as happened in the 1970s and some people fear may be happening now. But the relationship does not appear to be stable across inflationary regimes. — Commodity returns tend to be much more volatile than inflation, making it difficult to predict how the two will move together.Source: DB Global Markets Research 25
  • Inflation: What To Do About It if You‗re Worried Property can hedge against inflation if rents can rise — DB Global Markets‘ research has shown that property returns are Property vs unexpected inflation positively correlated with inflation, although the correlation is weak. This suggests that property can be a partial hedge against inflation. However property is illiquid and suffers from large transaction costs. — Other research1 has shown a difference based on the type of real estate. Retail property tends not to provide good inflation protection, because renters have a hard time passing along price increases to customers and therefore landlords find it difficult to raise rents. — Offices on the other hand have provided protection against both expected and unexpected inflation. Residential property was even better, probably because home owners have market power and can raise rents, given that there are few substitutes for housing. — Real estate equities however are no better than other kinds of equities at protecting against inflation. On the contrary, theSource: DB Global Markets Research, Bureau of Labor Statistics, US Census Bureau, Bloomberg correlation between real estate equities and inflation is negative.Finance L.P.Total return on property = price return + rental yields – maintenance yield. This may be because interest rates tend to rise when inflation rises.*1 Demary , Markus and Voigtlander, Michael, “The Inflation Hedging Properties of Real Estate: AComparison Between Direct Investments and Equity Returns,” Research center for Real Estate — Another paper2 concluded that as acceptable risk levels rise,Economics, Institut der deutschen Wirtschaft Koln, Germany. Available on the web at timberland supplants commercial real estate as the primaryhttp://eres2009.com/papers/5Dvoigtlaender.pdf allocation to real estate in a diversified portfolio.2Waggles, Doug and Johnson, Don, “An analysis of the impact of timberland, farmland and commercialreal estate in the asset allocation decisions of institutional investors ,” Review of Financial Economics,Vol. 18, Issue 2, April 2009 26
  • Inflation: What To Do About It if You‗re Worried Index-linked bonds vs nominal bonds: a matter of timing IL bonds outperform in unexpected inflation — As mentioned earlier, long-term bonds are the worst performing asset immediately following an inflation shock as yields rise. Eventually though real yields rise and nominal bonds begin to perform again. — The graph shows that conventional bonds outperform index-linked (IL) bonds when inflation is below expectations, but IL bonds outperform when inflation is above expectations. — Over the last 13 years, there has been little cumulative difference in the total return from the two. Long (5~10yr) IL bonds have returned 146%, vs 149% for conventional bonds, with nearly the same volatility of returns. — The optimal strategy would be to move into IL bonds early in the inflation cycle and shift back into nominalSource: Deutsche Bank Global Markets, BoA/Merrill Lynch bonds once real interest rates start to adjust.— Developed economies issuing IL bonds: — The current environment is one where actual inflation has exceeded expectations and hence is a negative — US, UK, France, Italy, Germany, Greece, inflationary surprise. Comparing our forecasts with the Japan, Sweden, Canada, Australia, Israel market consensus, we expect inflation over the next two— EM countries issuing IL bonds: years to be largely in line with market expectations and — Brazil, Mexico, South Africa, Turkey, Poland, therefore offer no further negative inflation surprise. We Chile, South Korea, Uruguay therefore cannot recommend TIPS at this point. 27
  • Inflation: What To Do About It if You‗re Worried Where to put your money: a diversified portfolioGIC recommended asset allocation (as of 26 April) Hyperinflation Deflation — Given that there is not one investment that can be guaranteed to provide a positive real return in an inflationary/rising interest rate environment, we believe the best course of action is a diversified portfolio. — We present here our Global Investment Committee‘s recommended asset allocation for the ―average‖ client. — Of course, each investor has his or her own needs and preferences and so this general portfolio would have to be tailored to their specific requirements.Source: Deutsche Bank Private Wealth Management Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 28
  • IMPORTANT NOTICEPrivate Wealth Management offers wealth management solutions for wealthy individuals, their families and select institutions worldwide. Deutsche Bank Private WealthManagement, through Deutsche Bank AG, its affiliated companies and its officers and employees (collectively ―Deutsche Bank‖) have published this document in good faith andon the following basis.This document has been prepared without consideration of the investment needs, objectives or financial circumstances of any investor. Before making an investment decision,investors need to consider, with or without the assistance of an investment adviser, whether the investments and strategies described or provided by Deutsche Bank, areappropriate, in light of their particular investment needs, objectives and financial circumstances. Furthermore, this document is for information/discussion purposes only anddoes not constitute an offer, recommendation or solicitation to conclude a transaction and should not be treated as giving investment advice.Deutsche Bank does not give tax or legal advice. Investors should seek advice from their own tax experts and lawyers, in considering investments and strategies suggested byDeutsche Bank. Investments with Deutsche Bank are not guaranteed, unless specified. Unless notified to the contrary in a particular case, investment instruments are notinsured by the Federal Deposit Insurance Corporation ("FDIC") or any other governmental entity, and are not guaranteed by or obligations of Deutsche Bank AG or its affiliates.Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not berelied upon as such. All opinions and estimates herein, including forecast returns, reflect our judgment on the date of this report and are subject to change without notice andinvolve a number of assumptions which may not prove valid.Investments are subject to investment risk, including market fluctuations, regulatory change, possible delays in repayment and loss of income and principal invested. The valueof investments can fall as well as rise and you might not get back the amount originally invested at any point in time.This publication contains forward looking statements. Forward looking statements include, but are not limited to assumptions, estimates, projections, opinions, models andhypothetical performance analysis. The forward looking statements expressed constitute the author‘s judgement as of the date of this material. Forward looking statementsinvolve significant elements of subjective judgements and analyses and changes thereto and/or consideration of different or additional factors could have a material impact onthe results indicated. Therefore, actual results may vary, perhaps materially, from the results contained herein. No representation or warranty is made by Deutsche Bank as tothe reasonableness or completeness of such forward looking statements or to any other financial information contained herein.The terms of any investment will be exclusively subject to the detailed provisions, including risk considerations, contained in the Offering Documents. When making aninvestment decision, you should rely solely on the final documentation relating to the transaction and not the summary contained herein.This document may not be reproduced or circulated without our written authority. The manner of circulation and distribution of this document may be restricted by law orregulation in certain countries, including the United States. This document is not directed to, or intended for distribution to or use by, any person or entity who is a citizen orresident of or located in any locality, state, country or other jurisdiction, including the United States, where such distribution, publication, availability or use would be contrary tolaw or regulation or which would subject Deutsche Bank to any registration or licensing requirement within such jurisdiction not currently met within such jurisdiction. Personsinto whose possession this document may come are required to inform themselves of, and to observe, such restrictions.Past performance is no guarantee of future results; nothing contained herein shall constitute any representation or warranty as to future performance. Further information isavailable upon investors request. Deutsche Bank Marshall Gittler Private Wealth Management 2011 Family Office & Wealth Management Conference 29