Personal view: Inflation and deflation hedges

published 6 March 2008

Every week, a professional investor tells MoneyWeek where he'd put his money now. This week: Charles MacKinnon, Thurleigh Investment Managers

There is a state of disquiet as to what will happen to equity markets over the coming year or so. The question mark hangs over which direction markets will go, rather than how far they will rise. This means that choices that would be conservative given one set of outcomes would be deeply foolish in light of the other set of outcomes.

On one hand, many people are worried about inflation. Global demand for land, food, heat and light has reached breaking point. Developing economies will pay ever-increasing prices for scarce resources. Inflation will be further fuelled by weak, politically-driven central banks, which will print money to protect the status quo in their domestic economies. Western economies are faced with spiralling costs, resulting in rising prices. This will inevitably end in a series of collapses as individuals, companies and currencies crumble under the weight of their debt and paper money becomes devalued in favour of physical assets. Think Zimbabwe now, or Germany before the war, with people wheeling barrows of paper money to buy a loaf of bread.

On the other hand, some people fear deflation. Their argument goes like this: after a decade of unbridled credit creation, every individual and institution has borrowed as much as, or more than, they could possibly afford. The resulting balloon is being punctured by the collapse of house prices and problems with the whole shadow banking system (Think Northern Rock and Socit Gneral). Our current prosperity is therefore built on sand. Sources of credit have dried up, and even the most creditworthy borrowers can no longer obtain funds to continue their business. A multi-year period of retrenchment while balance sheets are rebuilt will mean a deep, dramatic fall in the values of those inflated assets.

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In this environment, physical assets collapse in value and assets that carry a secure income become attractive. Take Japan for the last 15 years: real estate has fallen 80% in value, while government bond values have soared as interest rates have gone from 3.25% in 1992 to 0.25% in 2007; or consider the Great Depression in the US in the 1930s.

Which way will the cookie crumble? Do we face inflation or deflation? I am not yet sure, but central bankers are clearly more worried about deflation, and so are pouring credit and cash into the financial system to try to stave it off. As a result, what I am buying right now is Schroders Commodity Fund (0800-718777), which can invest over the whole range of consumable commodities.I feel certain that there will be continuing, increasing demand for food and energy. I am not sure if this will look good in six months' time, but in a year or so I'm certain this move will pay off.

I am also buying the S&P 500, via the iShares S&P 500 (IUSA) exchange-traded fund. The values of large, US-based companies have barely risen over the last decade, despite strong balance sheets and successful innovation.

Finally, I am buying the UK Index-Linked 2.5% Gilt, maturing in 2024. This will afford some protection in the event of a short period of inflation, and it will offer a significant buffer in the event of a long period of deflation. I do not expect to hold this bond for very long, as once it becomes clear which way the world is going, it will have done its job.