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Inflation: portfolios’ enemy number one

Are you an inflation bear or bull? The global investment community can be roughly divided between those who see little real inflation risk – often pointing to the record level of excess capacity in world's economies as measured by the "output gap" – and those who believe that although many regions are currently experiencing deflation, inflation will return with a vengeance.

The reason for the second group's pessimism is simple. Amid a period of historically low interest rates, governments have been accumulating huge debt levels to bail out the banking system. Consequently, central banks have been adding an array of monetary and fiscal assets – most visibly quantitative easing – to boost growth and inflation in the short term.

"There has been a profound shift in the balance of power between government and the market, which has shifted in favour of government and becomes a central factor for all investors including family offices," says the Honourable Dr Philippa Malmgren, president of the Canonbury Group and a former special assistant to the president of the United States for Economic Policy on the NEC.

Malmgren has no doubt that governments' actions will succeed in generating inflation, which is why her view on its importance is so profound. "Most people in the financial markets have dismissed inflation and this is a mistake. Inflation is going to be the single most important thing to consider when planning your portfolio for the next few years," she says.

This is a view shared by Jerry Haworth, founder of 36 South, a London-based hedge fund investment manager. "I believe inflation will be a significant part of our landscape for the foreseeable future," he says. "Inflation is the main cause of long-term destruction of wealth and should be taken seriously."

Both believe the trend will be global as governments around the world follow a similar strategy, which will cause currencies to depreciate. Both also agree that inflation is already here: "We don't have to wait for inflation, you can already see it, that's why the oil prices are back up at over $60," says Malmgren. "How else can you explain that in a world where unemployment is increasing, the oil price goes up?"

However, according to Haworth, because everyone is doing the same thing, depreciation will be much harder to spot and inflation will first be noticed in commodities. Malmgren also sees commodities as the driver, but puts it down to a lack of future supply. "The credit crisis has shut down so many wells and mines and so much agriculture around the world that naturally you're going to get a supply-side shock," she says.

The question for family offices therefore is what to do about this shift. Malmgren believes family offices must first address their investment philosophy. "Every investor has to decide what the most important thing is to them; performance or preservation of capital," she says. "My view is that if you seek to preserve your capital you will get performance. If you seek performance, you may not preserve your capital."

Fundamentally, it all comes down to a reassessment of your investment strategy. "Traditional asset allocation strategies and a philosophy of 'set and forget' are going to be completely abandoned," predicts Malmgren. In its place, investors will need to identify a theme, such as inflation being more of a driver than deflation, and decide on how best you want to express it.

To profit from what Malmgren sees as the best investment opportunities she has seen in her career, investors are advised to focus on real assets such as commodities and real estate as a hedge against inflation. "Specifically I'm looking at agriculture, land transformation – which focuses on making land productive – sugar, soy beans and rare earth metals that are integral to manufacturing," she says.

Haworth suggests looking at buying bonds whose coupons are linked to the level of inflation as measured by the Consumer Price Index. However, he cautions that CPI numbers are generated by government departments who "tend to find ingenious ways of toning down the numbers to make inflation appear less virulent than it really is."

He also says there is "a massive overhang" of property from the last bubble which could take five years to overcome whilst inflation could move up significantly in the interim. Both Malmgren and Haworth are so convinced by the inflation argument that they have put their money where their mouths are. Malmgren has set up an asset management company to focus on this niche, while Haworth's hedge fund specialises in inflation hedges by buying long-dated options on inflation assets which will provide an impressive ROI should there be significant inflation.

Betting on inflation remains a gamble – as Haworth says, the biggest risk to his inflation-linked hedge fund is that deflation becomes the dominant force – but Malmgren says doing nothing at all is the biggest risk. The key to which risks you should take lies in one simple concept: do you believe that the relationship between inflation and deflation is linear or simultaneous. "I think you face downward deflationary pressures and upward inflationary pressures at the same time, so what you have to do is judge the relative pressure," says Malmgren. Both will be hoping that their bullish stance on inflation will provide handsome reward if a volatile future.

Dr Pippa Malmgren will be speaking at the European Family Office Conference. To register, please visit

Warren Buffett is not a genius

Philippa Malmgren says family offices will have to be much more proactive with regard to their investments in the future. "Nothing is set in stone and markets are no longer trending," she explains. Instead increased volatility will create a stop-go environment – similar to that of the 1960s and 70s – where both inflation and deflation signals are present at the same time. The consequences for family offices are clear. You can no longer hope to ride out the bad time because of a long-term focus that ensures you will profit in the good times. "That's wrong, there is no question about it," says Malmgren. "You may make money in the good times but if you leave an investment alone for too long you'll get whacked."

When Campden FO probed her on the success of investment gurus such as Warren Buffett, who famously advocates long-term investments, the riposte was categorical. "Buffett was hugely successful but look at the period in history where for 30 years we have had trending markets. Now we're not and my bet is that his approach will not pay over the next 15 years." In other words, says Malmgren, Buffett is not a genius, he just had the right philosophy for the moment. Family offices the world over will be hoping the investment strategies they are putting in place now will correctly position them to profit from this new investment age.


debt, inflation, portfolios
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