Tuesday, October 14, 2008

About inflation

A number of independent writers have expressed concerns of deflation, while others such as Peter Schiff have repeatedly maintained that developed nations, particularly the US, face unprecedented inflation. So who is “correct”? Who cares. The more important question lies in mechanics of staying profitable alongside this uncertainty.

Exploring both scenarios

In an exaggerated inflationary period, we expect the following:

  • Bullish stock markets
  • Very bullish commodity prices
  • Very bearish debt instruments (treasuries, corporate bonds, etc.)
  • Real estate bubble build up
  • Lowered general market volatility
  • Bankrupt companies fall, but the execs go away and have another go easily

Conversely, in deflationary periods (or inflation slow downs) we have seen the below:

  • Sharp declines in stock markets as volatility increases
  • Commodity/real estate prices come back and adjust to the actual rate of inflation
  • Fixed income debt instruments tend to rally
  • Financially unstable firms go down, alongside the long-side investors

Traditional hedges

Many investors hedge against exchange rate risk by holding a basket of different currencies. This still leaves the risk of currencies losing value collectively like what we have seen the last few weeks, though they have more to gain if inflation slows.

Some solutions

Commodities and real estate are probably the “safest” in this period. As they have intrinsic value, and true “deflation” would never occur with the current credit based financial system. Inflation slows or picks up pace, either way over the long run (years), commodity and land prices will always adjust and rise with respect to paper money.

Shorting companies on the verge of insolvency “works” regardless of inflationary concerns. Badly managed, heavily geared, non-performing businesses inevitably lose investors’ confidence. These stocks head toward $0 as statistical eventualities, the rate of inflation simply determine the speed of it. So even in the case of high inflation, a “slow death” via a thousand cuts (I think that’s a line from some Kung Fu movie) would still reward the short seller with a nice return.

Short term arbitrage of course works regardless of any market or monetary conditions. This just takes much more critical thinking and probably physical work to both search out and exploit discovered inefficiencies. Now that the Chinese stock markets have started experimenting with short selling, many new opportunities have opened.

That’s all for now.

0 Reflections: