Some thoughts on inflation, gold and real estate

Economists are still debating whether inflation is back in the global system, while it is pretty obvious to any living soul that prices are higher than they were a year ago. Oil is the culprit. Surging energy costs are driving up the cost of anything from air fares to dry-cleaning.

Optimists think oil prices will plunge sometime next year, restoring the status quo. Yet that still means that inflation is out-of-the-bag, and it will be some time before prices start to fall in the shops, if they ever do. And assuming that oil prices do not remain stubbornly higher, which does seem the most realistic scenario in view of declining supply from producers such as the UK and Russia.

So if inflation is back with us: and expect the official inflation figures to start to rise next year; then where on earth should investors stash their cash to avoid the ravages of inflation?

Fixed assets

Fixed assets are one answer. Inflation tends to carry the valuation of fixed assets upwards. Thus, for example, you buy a house with a mortgage, then over time the value of the house grows and the mortgage will stay the same.

For over-borrowed countries like the US and UK, this is a helpful side to inflation. However, central banks also tend to raise interest rates to counter inflation and this puts an increasing burden on debt interest payments, so owning fixed assets with a high debt may prove a disaster.

For shares the same caveat applies. High inflation may increase the value of shares over time but a high interest rate environment will generally be bad for shares that have to compete for investment with bank accounts.

One investment to avoid at all costs in a higher inflation environment is fixed-rate bonds, as the rise in interest rates to combat inflation will hit bond prices. We have seen bond prices rise in recent years on the back of very low interest rates, and this is almost bound to reverse thanks to inflation.

Precious metals

The classic hedge against inflation is gold and silver, and other precious metals. The whiff of higher US inflation this week sent gold back to a 17-year high of $478 an ounce. It is only to be expected that higher inflation will take gold higher, probably past the $500 an ounce barrier and then onwards to $600 an ounce.

In such a bullish market for gold the best returns are generally obtained by buying the larger gold mining stocks rather than physical gold, and later on the smaller capitalized gold mining company funds. Oil too should not be forgotten, as oil stocks remain cheap in relation to the price of oil.

For inflation can be the friend of the savvy investor. But the reverse of most of the investment assumptions of recent years may apply which will catch many unaware.