In the past five years since the onset of the 2008 financial crisis, it has been tempting to view the key investment choices through either end of a long scope with one view depicting inflation and the other deflation.

Seeing the world in polar opposite terms, or binary terms, leads to quite distinctly  different asset allocations. In a deflationary environment, cash and government bonds (both nominal and linked) are the assets of choice whereas, should inflation reign, equities should be preferred over bonds or cash and other putative real assets such as commodities and properties become legitimate alternatives.

Some asset managers, Ruffer springs to mind, have defined themselves by an historically referenced projection of hyperinflation and have made sympathetic allocations.

For a while, we were swayed by this line of reasoning.  In the early part of the crisis period, key global economies veered toward deflation at an alarming rate, and whilst Central Bank and Treasury intervention did avert this, the threat persisted for a good deal longer than the performance of risk assets would suggest. It was argued that Central Banks, by debasing fiat currency values, would create high or hyper-inflation as they took gargantuan steps to avert negative inflation (deflation).

However, we abandoned the axiom, recognising that whilst monetary expansion might be a necessary condition to generating inflation, it is not a sufficient one.  It seemed to us that there was too much store placed in the belief that QE would generate the continued outperformance of gold and inflation linked bonds and other assets labelled “inflation protection”. Our own work suggested that very few assets, perhaps none, should be regarded as offering water-tight inflation protection.

They fail for various reasons.  The failure of gold and equities is observable from history.  Inflation linked bonds, which is a relatively new asset class, fail on account of their direct linkage to nominal bonds. ILBs are in fact not a real asset at all but a nominal asset with an indexed cash-flow stream. ILBs have only existed in an era of disinflation, so are not that well understood by the investing community at large.

Better returns have been possible by underpinning asset allocation with a forecast that global inflation remains within normal boundaries, neither deflationary nor hyper-inflationary.

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