Friday, January 17, 2014

Money Managers Go Big on Inflation

Top 5 Safest Stocks For 2014

Print FriendlyYou should always remain aware of what large investment houses and asset managers are thinking, because they tend to set new trends given the sheer size of their trades.

The major institutional investors are now buying investments in anticipation of inflation, which means that independent investors who act too late may get crowded out of buying inflation-proof securities at reasonable values. And as noted in previous columns, we also believe that higher inflation is on the horizon.

Moreover, while each individual investment should always be evaluated using an objective method—such as price-to-earnings, discount cash flow or return on equity—it’s also shrewd to follow the trends that are shaping the investment universe.

As far back as 1936, famed Economist John Maynard Keynes compared the stock market to a beauty contest. He described a newspaper contest in which 100 photographs of faces were displayed. The winner would be the reader whose list of six came closest to the most popular of the combined lists of all readers. The best strategy, Keynes noted, isn’t to pick the faces that are your personal favorites; it’s to select those that you think others will think prettiest.

We know from various 2014 outlook reports from some of the biggest money managers that inflation will be the prettiest of all in the upcoming beauty contests, generating high demand for investments that can protect against inflation. That’s why you shouldn’t tarry in obtaining low-priced inflation protection.

In a recent research note, fund managers at PIMCO projected that the core consumer price index (CPI) would increase to 2.1 percent by the end of 2014 (see Chart A). The asset firm expects oil prices to hover in the $105–$110 per barrel range and food pric! es to remain stable, which puts its headline CPI forecast at around 2 percent year-over-year in 2014.

Chart A: PIMCO Predicts Core CPI or Inflation to Rise in 2014

Although PIMCO’s fund managers believe inflation will increase year over year, they nonetheless expect personal consumption expenditures (PCE) to remain below the Fed’s 2 percent target, at around 1.5 percent. The Fed has renewed its focus on raising the inflation rate toward its 2 percent target for the PCE price index, which differs somewhat in composition and scope from the more widely recognized CPI.

“We expect consumers will find that the pace of rental inflation is increasing. Food and gasoline prices will be relatively stable. Medical and education costs continue to grow, albeit at a slower pace than in recent years. Automotive prices are likely to be relatively stable, as will the price of imported consumer goods. And airfares are likely to be relatively steady after increasing strongly over the past year,” the PIMCO fund managers predict.

What this all means is that PIMCO is advising its clients to jump into Treasury Inflation-Protected Securities (TIPS), which they believe is an attractive investment right now because the market is implying a CPI Inflation of only 1.4 percent over the next year, while as previously mentioned PIMCO believes inflation will hit 2 percent.

You don’t necessarily need to look at fund manager reports to conclude that inflation may be just around the corner. Various media reports and changes in the TIPS markets are confirming US inflation expectations have jumped to their highest since May, with central banks and investors seeking insurance against the prospect that a recovering American economy will stoke price pressures.

Inflation expectations, as measured by the difference between yields on 10-year nominal Treasury notes and TIPS, have risen to 2.28 p! ercent fr! om a low of around 2.10 percent a month ago, as of the market close on Jan. 8. TIPS help insulate holders from the threat of rising prices, because their value increases when the seasonally adjusted CPI rises. In contrast, holders of fixed-rate bonds suffer as inflation erodes their value.

PIMCO is not the only player to have spotted this trend. According to a recent Financial Times report, “as the new year began, modest exchange traded fund outflows are being outweighed by demand from foreign central banks and other long-term investors focused on seeking inflation protection as it is seen as being a buying opportunity in the wake of the asset classes’ underperformance in 2013.”

Furthermore, TIPS aren’t the only investment that is being targeted for inflation protection.

Commodities, Emerging Markets and Currencies

In recent research notes, PIMCO is now making declarative statements about the future rise of commodities, overseas currencies and emerging markets. For example:

On Commodities: “Given the global supply/demand imbalances that we see, we expect commodity prices to be generally rising going forward, noting, of course, that commodity prices are volatile and that there will be differentiation among commodities.”

On Emerging Markets: “Emerging economies face their own inflationary pressures. They may find that they cannot continue to couple their currencies to the US dollar and to combat inflation they need to let their currencies appreciate.”

On Currencies: “Currencies may become another strong driver of inflation, especially among developed economies. We anticipate policymakers in the developed world will attempt to make their economies more competitive via a cheaper currency, which likely will, for net importers like the US, lead to higher inflation.”

To combat inflation, PIMCO advocates commodities that have two characteristics: 1) They’re geared to global growth, and 2) th! ere are s! upply constraints.

The two commodities that they feel fit this criteria are crude oil and copper. “Both of them are strongly connected to global growth and emerging market growth in particular. And both have significant supply constraints such that, if demand growth continues at the same pace for the next couple of years as it has been, we could see significant supply shortfalls,” the PIMCO managers argue.

But other fund managers are focusing on the one metal that has been historically a safe haven to preserve wealth during inflationary periods—and that’s gold.

On Jan. 16, gold advanced for the first time in three days after a government report showed the cost of living in the US increased by the most in six months, boosting the appeal of the precious metal as a hedge against inflation.

In terms of emerging market holdings, investors are diversifying their portfolios in droves to emphasize safety or fixed income rather than growth. Emerging market fund investors poured money into bond portfolios and cash while selling equities in the first full week of 2014, in contrast to the apparent start of the “great rotation” at the beginning of last year.

In fact, since the start of the year, emerging-market sovereigns have sold almost $19 billion of bonds, three times what was sold at this stage last year and the fastest start to the year since Dealogic started compiling records in 2000.

With respect to bond funds, bond data provider EPFR Global found European bond funds benefited from their largest inflows since late April 2013, and emerging markets local currency bond funds broke a 14-week outflow streak to capture new money (see Chart B).

Chart B: Emerging Markets Bonds will Continue to Outperform

In sum, if there ever was a time to prepare for inflation, and access such protection at reasonable prices, the time is now, before the g! lobe̵! 7;s behemoth investment institutions crowd out mom-and-pop investors.

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