How to defend yourself against high inflation

One of the few bright spots in the economy has been the fall in inflation. Lower energy prices have helped push the headline rates in both the US and UK down. Core inflation (excluding energy and food) is now just above 2% in both countries. While it doesn't solve all our problems, it certainly provides breathing room for the consumer.

However, this is likely to be brief. In the long run, inflation is the least painful way out of our current economic malaise, which is why it's the path our leaders will try to force us down. Here's what you should do about it.

Inflation versus austerity

I recently attended a presentation by Peter Spiller of Capital Gains Asset Management, hosted by Halkin Services, who had some very interesting points to make on this topic.

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When a country is faced with a large amount of public and private debt, it has several options. But they boil down to two main choices. One is the path of austerity, with cuts in public spending and nominal wages. The obvious case of this happening is in the US from 1929 to 1933.

The other is to adopt policies that will inflate the debt away.Examples of this are Italy between 1975 and 1987and the US in the immediate aftermath of World War Two.

Of the two options, austerity is very tough to implement. This is because firms find it hard to cut prices and wages. So they usually end up reducing output and letting staff go. This creates high economic and social costs. As a result, governments who pursue such policies quickly become unpopular.

Ironically, austerity may also lead to higher prices. This is because a key part of cutting public spending is the removal of subsidies for certain goods. Governments may also try to raise revenue through higher consumption taxes.

So given that inflation presents the easy' option certainly in the short term it's the obvious choice for the people in power.

China has repressed global inflation but that's coming to an end

There's another, more fundamental problem that points to inflation rising. At the end of the 1970s, China began to open up, slowly moving towards a more market-based model. At the same time, other low-cost Asian countries also began to emerge as major producers. This had a major effect on global prices.

The availability of a large pool of cheap labour made it possible to produce goods cheaply, which were then exported to the rest of the world. While the price of services has usually grown faster than that of goods, the gap between the two widened during this period. This kept overall inflation down.

However, most of China's gains from their (limited) market reforms are now exhausted. The pool of rural workers is now shrinking, pushing up labour costs by an estimated 10% year-on-year. This means that China's negative effect on prices has now started to reverse.

Indeed, it now plays a major role in driving up the price of commodities. While UK goods inflation was negative up until mid-2005, it is currently running at more than four percentage points higher than services inflation.

While we believe that China's appetite for commodities is dropping off, which takes some pressure off prices that way, a return to the days of never-ending cheap goods coming from China is far less likely. If the country is to have any hope of shifting its economic model towards a more consumer-based economy, it will need to shift its focus decisively away from making high-volume, low value-added goods, and towards more profitable businesses.

An example from history

So where are we heading now? As noted above, one period that might serve as a useful model is the 25-year period from 1945.

Most governments were left with large amounts of debt from World War Two. Instead of trying to cut spending (as they did after World War One), they instead inflated it away. According to the Bank for International Settlements, the average real interest rate on deposits in advanced economies was -1.94% (ie, nearly 2% below inflation). Indeed, during the late 1940s and mid-1970s, interest rates were as much as 5% lower than inflation.

It seems more likely that this is the route governments will take this time indeed, the Bank of England has not shown any real appetite for tackling inflation in the UK, and real interest rates have been negative for several years now.

So how can you protect your wealth?

A study in the 2012 Credit Suisse Global Investment Returns yearbook provides some clues.

Experts Elroy Dimson, Paul Marsh, and Mike Staunton studied the real returns of several assets against inflation, in 19 countries over 111 one-year periods. They found that inflation lowers the real returns of bonds and bills (short-term government deposits). This should not be a surprise - the whole point of increasing inflation is to get national income growing faster than debt.

So you want to avoid government bonds - those of Germany, Britain and the US in particular offer poor value. While quantitative easing (QE) has keep bond prices artificially high, my colleague John Stepek thinks that UK gilt prices are in a bubble, which could burst at any time.

The effect on shares is more mixed. Overall, the study found that inflation had a negative effect on real returns. While this may seem strange, there are several reasons for this. At the very top of an economic cycle, when an economy is overheating, investors may be worried that interest rates are about to start rising. Similarly, cost-push factors, such as rising wages or higher energy costs may hit margins. During the stagflation (high unemployment and inflation) of the 1970s, stock returns were negative.

Because tax levels aren't adjusted higher along with inflation, rising prices may also make shares less attractive.

However, at the bottom of the economic cycle, when deflation (falling prices) is a worry, inflation may be good for returns. This is because it reduces the real value of debt and boosts demand. From the late 1940s to the late 1960s, stocks surged, with strong real returns. Economists Leigh Skene and Michael Oliver have also found that the start of many bull markets coincided with increases in the money supply, which should be inflationary in the long run.

The UK and many eurozone economies are in recession. Experts also think US growth will be low. This therefore puts us closer to the scenario of inflation being good for firms and markets, assuming that central banks can ignite it. However, if crude oil rises back to the levels seen earlier this year, markets could get clobbered.

However, there's one asset that benefits from both 'good' and 'bad' inflation: gold. Dimson, Marsh, and Staunton found that the metal had a positive relationship with inflation. While the price of gold has been fixed through much of the 20th century, including the immediate postwar period, it performed very well during the 1970s. It's another good reason to hold it as insurance and now might also be a good time to look at gold miners.