What to avoid and what to buy as inflation makes a comeback

With the war on deflation in full swing, the threat of inflation making a return is real. John Stepek explains the one asset to avoid – and one to buy.


Central banks are continuing the war on deflation

The war on deflation continues in earnest.

No sooner had MoneyWeek's "helicopter money" cover hit the newsstands than I seemed to be reading about helicopter drops all over the place.

The European Central Bank's (ECB) chief economist, Peter Praet, suggested on Friday that the ECB might be open to using it (that is, printing money to pump directly into the economy, with no way to take it back).

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Meanwhile, in the US, the Federal Reserve seems to have given up on worrying about inflation, despite core inflation already being above the Fed's target level.

If there's any truth to any of this, there's one inflation-vulnerable asset that I'd be very worried about indeed bonds

The bubble in bonds

You hold an AAA-rated bond because you are as close to certain as you can be that the issuer won't go bust. As a result, the calculation of its value is pretty straightforward.

You give the company or government in question £100. They promise to pay you a certain income every year in return. And you get the money back in the end.

You don't expect a huge amount of money back. But as long as the return keeps up with inflation and compares well to other "safe" sources of income, you'll go for it. It's not a million miles away from a bank account you don't get the deposit insurance and you shouldn't consider it in the same light as cash (especially not now), but it's serving a similar function. It's meant to be low risk.

That's where it's getting tricky. Many bonds don't pay any income at all these days. And that's a problem. Because an income plays another important role: it protects you from bond price volatility.

You see, bonds trade in the secondary market just like shares. So their prices go up and down, depending on how people view their prospects. That might not matter if you plan to hold the bond to maturity (ie until it pays out) but it does matter if you want to sell before then.

As it is, if you buy a bond on a yield of 10%, then the price of that bond can fall quite hard, and you could still end the year in the money your total return could still be positive. (This is one reason why 1994 when the Federal Reserve under Alan Greenspan badly rattled the bond market by raising rates earlier than expected turned out to be relatively benign.)

But when your starting yield is near-enough 0%, there's no cushion to save you at all. Joel Lewin wrote an interesting piece for the FT at the end of last week that demonstrates the impact.

If you own a German ten-year bund, then data from Markit shows that "it would take a mere 5.1 basis point rise" in the yield "to erase the next 12 months of returns". In other words, if the bond yield rises by just 0.051 percentage points, then your total return for the year would be 0%.

For the Japanese ten-year, it's just 0.016 percentage points. As Markus Allenspach of Julius Baer puts it: "It's return-free risk. If there's a slight yield move, it's almost impossible to recover."

We've already seen the impact. AAA euro corporate bonds endured their worst quarter ever in 2015, falling by 5.44% (that's the worst since the second quarter of 2008, when they only fell by 2.32%). Overall, it was the worst year ever since 1999.

Now, we've run through the various reasons why people might be happy to buy bonds at these levels in the past (there are three: currency speculation, momentum trading, or a genuine belief that "this time is different").

These are all valid reasons, but they're also classic "bubble" reasons. Based on the "fundamentals", most people would have to admit that "safe" bonds are at the very least expensive.

With inflation stirring in the US and the Federal Reserve apparently unconcerned about it, I do wonder how long the bubble can continue to defy reality.

Gold miners are still looking good

Yet there could easily be more to go, it seems. According to Bloomberg data, if you value gold miners based on their gold reserves, then they are currently nearly 20% cheaper than they were about a year ago.

This is partly because "production costs are down by about a quarter from 2012", falling from $1,245 an ounce in September 2012 to $936.20 at the end of 2015.

This is pretty much the point that Edward Chancellor made in MoneyWeek magazine back in December, before the rally kicked off in earnest. Chancellor noted that if you consider the "capital cycle", then the timing for investing in gold miners was ideal.

Gold miners having endured a painful bear market have been forced to cut costs, ditch expensive developments, and generally become leaner, more efficient companies. That makes them far more attractive now than they were a few years ago. And the rebound in the gold price itself is just a bonus.

I'm hanging on to mine, that's for sure.

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John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.