How inflation can mean deflation for bonds, stocks and real estate

China is exporting inflation rather than deflation to the world. The US intends to cut its budget deficit but not if that means changing the American way of life. Japan has been printing hundreds of billions of dollars since its earthquake and nuclear crises.

Meanwhile, there is enough unrest and uncertainty in the Middle East and North Africa to keep oil prices north of $100 this year. All of these factors are inflationary. That means the cost of living is going up.

Investment implications

But what does this mean for investors in bonds, stocks and real estate? For equities at least there is some hope that profits will rise with inflation and support share prices. However, in practice rising input costs tend to squeeze profit margins in such an environment and that is not good news for equities.

The impact on bonds and real estate tends to be more immediate. Higher inflation will, sooner or later, have to be met with higher interest rates or lenders will not lend money. Higher interest rates directly impact on bond prices and send them lower.

That would not be so bad if banks did not need to refinance in the coming few years. But as the IMF warned yesterday the world’s banks face a $3.6 trillion ‘wall of maturing debt’ in the next two years.

Debt mountain

‘These bank funding needs coincide with higher sovereign refinancing requirements, heightening competition for scarce funding resources,’ the world’s central bank added. Clearly bonds are not the place to be invested as the ‘bond king’ Bill Gross eloquently argued this week (click here).

Higher interest rates are also toxic for the weak and falling property markets of the world. We have to look back to the 1970s for a similar era in global economics and learn from the lessons of those years.

In the 1970s the winning asset classes were cash (thanks to higher interest rates), oil and related assets, and precious metals. Volatility was so high that cash emerged as the overall winner for the average investor.

Gold and silver perform best when inflation is rising ahead of interest rates producing so-called negative real interest rates, and given the weakness of the global economy that is where investors are likely to sit for the next two or three years.