Inflation is coming... go buy real assets

Thu, 29 Mar Pre-Open

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If you just found out that a storm was on the horizon, what would you do? Most people would buy some essential supplies and wait it out till weather conditions improve. According to Bill Gross, the venerable co-founder of PIMCO, investors should buy commodities and real assets to save themselves from the coming inflationary storm. He believes that the world is likely to face much more monetary and credit inflation before the balloon finally pops.

The primary reason for PIMCO's pessimism is that the world is deleveraging. Since the early 20th century the world has been leveraging itself. In finance, leverage is a general term for a technique to multiply gains and losses. Over the years, besides the traditional banking system, new forms of credit were invented, including derivatives. But this wasn't risk free. There were many causalities along the way including, LTCM, the Asian Financial Crisis, Dot com bust, subprime crisis etc. However, through all this financial institutions and market participants learned that policymakers would try and support the system. They would keep their economies running either by extending credit, lowering interest rates, expanding deficits or deregulating markets. This combined fiscal and monetary leverage produced huge returns that exceeded the ability of real economies to create wealth.

The entire garden was flowering at the same time. PE ratios of stocks rose, bond prices of 30 year US treasuries doubled, real estate boomed. Everything investors touched turned to gold as the financial markets were being constantly levered. However, post 2008 thing have fundamentally changed. Financial markets are selectively deleveraging. This is being mostly seen in the United States and in peripheral Europe. Households are trying to fix their balance sheets and sovereign nations in Europe are also trying to mend their ways. Yet, the total amount of debt in the system is scary. Now real growth is needed as opposed to slick financial engineering. But, this growth is stressed by increased fiscal deficits and high Debt/GDP levels. Continued credit expansion is expected to produce global inflation and slower growth.

So what's the solution and what do investors do in light of inflation, slower growth, and lower leverage. Well, according to Bill Gross, one needs to invest in assets that have the potential to provide the most returns with the least amount of risk. Real assets such as commodities, land, buildings, and machines are a good start. Dividend paying stocks and other financial assets with strong balance sheets are also a good bet. In this case, developing market stocks are preferred over developed market stocks. Financial or real assets that are not burdened by excess debt and that can benefit from favourable fiscal or monetary policies are also preferred.