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Investment in a period of higher inflation

That the world has now entered a period of higher inflation after a long phase of very low inflation is clear from recent official figures. But so far capital markets have failed to adjust to this new reality aside from marking up energy and mining stocks.

Investors should be careful. Events like a shift towards higher inflation are just the sort of thing that catches out markets. For inflation changes the rules of investment and complacent investors will lose their shirts.

This week US inflation is expected to be headlined at 4% compared with a Federal funds interest rate of 3.75%, so real interest rates have turned negative. That means if you have your money in a bank account then you are losing money in real terms. But it could be worse.

Cash is King?

If you look at the late 1970s then the best performing US asset class was cash, as stocks had one of their worst periods in modern times and real estate prices fell in real terms. At its simplest level inflation is generally bad for company profits and therefore bad for stocks and the wider economy.

Of course, there are exceptions. Shares in companies related to energy and precious metals tend to perform well. Partly this is down to the relatively fixed supply of the asset relative to an inflating money supply; partly it is just that investors pile into these stocks for the same reason.

Investors in real estate should also worry about inflation. Real estate prices around the world have already been inflated by low interest rates.

Higher inflation means that not only will central banks be unable to cut interest rates if growth rates falter but that interest rates are also likely to go higher, accelerating the downside of the real estate bubble.

The only good news for borrowers is that the real value of their debts will be eroded by inflation, provided that they can handle the servicing costs. Hence, over time inflation can be a friend to the real estate speculator whose finances are not so precarious that they can not survive any market setbacks.

But if we look back to the 1970s and the last oil shock then stocks and real estate are unlikely to prove good investments. That leaves cash, precious metals and energy assets as the best options.

However, for many investors such an environment is more about protecting wealth against the corrosive effect of inflation, and investment gains are not likely to be very good.

There are still some analysts who believe that deflation may follow on from a short bout of inflation, but that might be getting a bit too pessimistic as even the 1970s did not get that bad.