Inflation can be your enemy…
Like the heat of summer, inflation is back to make its presence felt. After a brief decline during the financial crisis, prices are rising and eating into our wallets. Outside Japan, we expect the inflation rate in Asia to top 5% this year, peaking during the summer months. We see no pause in 2012, when we expect inflation to remain high at 4.5%. The United States (US) will not feel a similar pressure in the near term as its economy is still trying to get back on its feet. Once its recovery has progressed – and the US has seen its monetary base expand by a factor of four since the crisis – it’s only a matter of time before inflation catches up in this part of the world.

But how damaging is inflation really? Inflation occurs in the wake of an extraordinary increase in the money supply. More accurately, it means the erosion of the purchasing power of money for everyday goods and services. For example, looking at 32 years of price data in the US, we see that prices rose just below 4% a year on average. While clothing prices didn’t rise as much, and some electronic items like television even became cheaper, the cost of medical care and college tuition soared 6% and 7.7% respectively. To put it more bluntly, one education dollar in 1978 was worth a mere eight cents 32 years later.

But we do not have to look that far to see what inflation does to us. Rents have risen almost 8% a year since 2004 in Hong Kong and close to 10% a year since 2005 in Singapore.

This raises a question for investors: which assets can provide a store of value and, ideally, generate a return that exceeds the inflation rate? Fortunately, investors can position their portfolios to become more inflation-proof. Real estate, commodities and inflation-indexed instruments are among the classic choices during inflationary times, but as a further alternative, we will focus on stocks and how they behave against consumer-price movements.sector should outperform as higher oil prices drive earnings.

… But moderate inflation is your friend
Inflation is not necessarily bad for stock investors. In the US, we have found that during times when the inflation rate is below 2%, the average equity return is 8.5% a year; when it is above 5%, the return is 6.5%. A sweet spot emerges when inflation is between 2% and 5% – the return is an impressive 13.2%, and remains around the double digits even when adjusted for the inflation rate. What this means is that periods of moderate inflation lead to robust equity returns, both in nominal and real terms.

One explanation for this is that many companies can quickly adjust their prices to rising input costs when inflation is moderate, but not so much when it is rising too fast. The problem with high inflation is not only that prices are high per se, but also that they are typically volatile, which means there is price uncertainty, which then makes planning more difficult for companies. As the market does not appreciate uncertainty, it demands a higher equity risk premium, and this leads to a sub-par equity performance. That said, we do not expect inflation to surpass critical levels.

In Asia, inflation has been one of the factors holding back equity markets this year, and this summer could prove a turning point. Looking at three Asian high-inflation cycles – 2001, 2004 and 2008 – stocks retreated by up to 22% six months ahead of the inflation peak. In 2001 and 2004, however, markets staged double-digit rallies six months after the peak. Not surprisingly, 2008 was an exception as it was followed by the global crisis, which brought Asian markets plunging by more than 50%. One striking similarity across all three periods, however, is the consistency of sector performance: IT, materials and consumer discretionary stocks outperformed the benchmark after the inflation peak. Of the three, we focus on the latter two. Materials usually benefit when inflation becomes less aggressive (as long as the economic momentum is robust) while sales of consumer discretionary items tend to rebound when the rate of price hikes weakens.

We have called 2011 the year of equities, and this has been the case for the global benchmark year-to-date. With easing inflation rates, this could also come true for Asia. In any case, we remain convinced that equities will score well in preventing the loss of purchasing power for investors, and perhaps even putting some extra money into their pockets.