Time to brace for impact of inflation

PUBLISHED : Sunday, 21 August, 2005, 12:00am
UPDATED : Sunday, 21 August, 2005, 12:00am

Rising petrol prices, soaring rents and even surging Sevens tickets all suggest something is up in the local economy.

Inflation - a worry that investor's haven't had to consider seriously for decades - is suddenly back and higher prices are set to become part of the landscape for years to come.

In June, consumer prices rose 1.2 per cent from the same month a year ago, the highest inflation rate since 1998. Higher prices for rental accommodation and imported mainland food should underpin inflation this year of between 2 and 2.5 per cent, according to Deutsche Bank estimates. The unfolding picture, the bank says, is 'a steady rise in inflation' driven by appreciation of the yuan, which makes almost all goods and related services imported into Hong Kong more expensive. More worryingly, many analysts believe official statistics understate the true rate of inflation.

The emerging picture requires a completely new way of thinking when it comes to managing assets, financial advisers say.

One of the keys is to avoid the shares of highly-indebted companies and instead hunt out those that are cash-positive with strong balance sheets, according to Phil Neilson, managing director of ING Financial Planning. He believes aggressive interest-rate increases are inevitable as central bankers move to stem inflation. In the new environment, companies burdened with heavy debt should under-perform, and may even be forced to slash non-core assets. Those in better financial shape will acquire weaker competitors and strengthen their global brands. Likely winners are US technology companies which have slashed budgets and consolidated operations since the collapse of the Nasdaq bubble.

'The first message is that this [inflation] is positive sentiment and therefore this is a good time to invest', he says. 'Assets are going up in value, wealth is being created, jobs are being created.'

He likes commodities, oil producers, financial and technology stocks. If you are excessively leveraged in the real estate market, it may be time to lighten up. While it is a good idea to hold hard assets, such as property, as a hedge against currency debasement, remember that a sudden spike in interest rates could send prices tumbling. 'I don't think property should ever be avoided, I'm just saying don't become over-exposed on property,' he says.

Kevin Coppard, general manager of the Fry Group, says there are some big question marks hanging over the global economy, in particular, the direction of oil prices. Forecasts for oil prices by the end of the year range between US$40 and US$100 a barrel.

If oil spikes to crisis levels, the global economy will slow dramatically, potentially knocking shares and rewarding bond-holders. However such super spikes in energy prices are rare, and, if anything, tend to happen at the end of a commodity cycle.

Mr Coppard advises steering clear of stocks with high debt ratios, and being prepared to dispose of holdings if things turn ugly. 'Learn the lessons from the past: markets do move quickly if there is some concern,' he says.

He likes property in New Zealand, Asia and Europe, but advises avoiding the US where talk of a bubble leaves valuations looking stretched. Being diversified across commercial, residential and office real estate should also help to spread risk. 'Don't get too aggressive one way or the other,' he says.

Deutsche Bank analyst Jun Ma believes strong employment growth and the opening of Disney will improve the local economy in the months to come. The theme park is expected to create 10,000 jobs, which should bring the unemployment rate down to 5.3 per cent by year's end. The employment trends leave him bullish on local banks and consumer stocks. Avoid exporters, ports and shipping companies, he says, as these industries are beginning to suffer from slowing external demand and excess competition.

London-based Barclays Capital sees trouble in the world economy and the potential for much higher inflation. The bank's Larry Kantor argues central banks are repeating all the mistakes of the 1970s, flooding markets with liquidity at a time when prices are already heating up. 'The focus remains on maintaining growth rates,' he says. 'The key lesson learned from the 1970s is that monetary policy can not successfully accommodate oil shocks.'

The easy money should fire up the global economy, with real GDP growth forecast at 3.9 per cent this year and 4.1 per cent next year.

Among the bank's recommendations are Treasury Inflation-Protected Securities (Tips) which now look cheap given the high petrol prices. Today's pump prices have striking parallels with the 1970s - a decade plagued by an energy crisis that turned out to be poor for stock market investors.

From 1966 to 1981 the compound annual return on the Dow Jones Industrial Average was negative 0.4 per cent. The real return on long bonds for the period was even worse at negative 4.2 per cent. Gold was a stellar performer, returning 8.8 per cent annually for the period.

But according to Jeremy Siegel, author of the 2002 book Stocks for the Long Run, the laggard performance of the stock market during the 1970s is an aberration and equities are a good hedge against inflation. 'Higher future earnings will offset higher interest rates so that, over time, the price of stocks - as well as the level of earnings and dividends - will rise at the rate of inflation,' he writes.

Investors who look at the superior performance of the stock market during the past two decades might be tempted to sell down their holdings in anticipation of a bear market. But doing so could be a mistake, as excessive money printing make stocks a winning bet.

Kevin Coppard, general manager, Fry Group

Go for a balanced stock portfolio. Be alert to sudden changes in the market and remain prepared to

sell down at signs of trouble. Focus on property in New Zealand, Europe and Asia.

Phil Neilson, general manager, ING Financial Planning

Look for companies with strong balance sheets, little debt and recently under consolidation, such

as US technology firms. Avoid heavily indebted companies vulnerable to rising interest rates.

Go for commodities and financial services.

Barclays Capital

Central banks are trying to soften the shock of high oil prices with accommodative monetary policy ?

but this policy failed in the 1970s. Favours stocks over bonds, overweight Europe and Japan,

underweight US Jun Ma, Deutsche Bank

Jun Ma, Deutsche Bank

Disneyland winners are airlines, jewellery shops and restaurants. Go for banks and consumer plays

owing to higher wages. Avoid exporters, ports and shipping due to slowing external demand