Inflation - undertstated (2) - the implications

In part 1 of this post I made the point that CPI type indices which are typically used as proxies for inflation tend to understate the true rate of inflation. If inflation is understated this has a number of potentially significant implications for investors and for personal finance more generally. From a personal finance perspective, underestimating the rate of inflation on your future expenses can result in a significant underestimation of those future expenses. Try calculating the difference between household expenses growing at 4% pa compared to 3% pa over a period of 30 years.

Understating the true rate of inflation also has implications for investments. Bonds and deposits will be overpriced as a result. Inflation indexed annuities and bonds will also be overpriced. All of these instruments will show real rates of return lower than expected. Given that the nominal rate of return in bonds and deposits is very low already, the real rate will be even lower. In many countries it will be negative.

Equities I am less sure about. History suggests that equities are a better investment that bonds in times of inflation. However, pricing is often at least partly done on a comparative basis. If bonds are overpriced this may suggest that equity prices have also benefited from that mispricing as well. Similar arguments can be made in favour of real estate and commodities and just about any asset class.

Debt is under priced. In Hong Kong we have negative real interest rates already. An upward restatement of the rate of inflation would increase the size of the negative margin.

While I do not expect governments to restate inflation numbers any time soon as they need to (i) inflate their way out of massive deficits and debt levels and (ii) do so while managing inflation expectations, growing awareness of how unreliable and inaccurate CPI indices are has the potential to cause changes in the way people invest. Hard assets such as real estate, commodities and collectibles will become more in demand. People will become more reluctant to hold assets that do not at least have the potential to keep pace with inflation.

The biggest question of all is whether central banks will keep interest rates low in an attempt to stave of a recession or raise interest rates to try and cool inflationary pressure (which they are creating by inflating the money supply). My betting is largely on the former (at least until we see signs of an economic recovery). If this is right, then using debt to invest in assets such as real estate and equities is a logical investment strategy.

Inflation - understated (1)

PIMCO's Bill Gross joined the chorus of people who believe that inflation is understated (or, at least that CPI type indices understate the true rate of inflation). Mr Gross stated that the US CPI numbers probably understated the true rate of inflation by about 1%. Leaving aside the technical point that "inflation" is a measure of increase in the money supply rather than a measure of the rate of increase in the price of goods and services, the evidence seems very clear.

In Hong Kong, the most recently released figures show annualised inflation at 5.4%. Basic necessities have been the biggest contributors to this figure (food, utilities and housing). The few things that I can point to which have decreased are rates (i.e. property taxes) and wine which declined or were relatively flat due to tax reductions or waivers by the government or consumer electronics. The true rate of inflation can only be guessed at but to illustrate the point that the CPI index understates the true rate of inflation, the most recent adjustment for jewellery can be used. In the 2007 adjustment to the CPI weighted basket, the percentage of household income spent on jewellery was slashed to a fraction of the figure used in 2003. Given that the economy was booming in 2007 and was in recession in 2003, the reverse should have been true.

In an environment where deposits earn next to nothing and dividend yields on the local stock index are around 3%, 5.4% inflation is high and a serious threat to both personal savings and standards of living. The fact that the real rate is higher still is scary.

Silver purchased

After exiting my position in silver several weeks ago, I have watched as the price of silver (and other precious metals) has consolidated. This morning I purchased a new position at HK$133.8 per ounce (US$17.15) including spread.

From a charting perspective we are now seeing signs that the precious metals have completed a consolidation phase and may be resuming their long term up trend. From a fundamental perspective, equity markets have rallied strongly over the last few weeks while precious metals (possibly excepting platinum which has lead the other precious metals) have lagged the equity markets. At the same time, concerns over inflationary expectations have received increased attention. The latter is generally considered to be bullish for precious metals.