有意思的笑话故事:The party's over

The party's over / 謝國忠

Stagflation has arrived, and coping with it will be the most important factor for investors

Andy Xie

The US Federal Reserve is suddenly talking tough about inflation. The market has now pencilled in a rate rise before the year ends. The European Central Bank is signalling that it may raise interest rates soon. The market fears an inflation crackdown by the central banks. Gold has declined, the US dollar has firmed and the yield curve has flattened. The talk is really aimed at bringing down oil prices. The surging price threatens to checkmate the loose monetary policy by the Fed and other central banks to support economic growth and failing financial institutions following the global credit-cum-property crisis.

But, the talk is likely to remain just that for a long time. While some rate rises may be forthcoming, they won't be aggressive enough - raising rates quickly, to above inflation rates. The bottom line is that the Fed can't accept a deep recession to put the inflation genie back in the bottle.

Excessive money supply in the past fuelled the credit-cum-property bubble. The inflationary effect of excessive money supply was temporarily contained by China's labour surplus and the collapsing demand for resources from Russia and eastern Europe. After decades of massive export growth, China's labour market is no longer a buyer's market. Russia and eastern Europe have begun to increase their resource demands. The inflationary effects of the past monetary excesses are now catching up with us. The first consequence of inflation's return is the bursting of the credit bubble.

The knee-jerk reaction of the big central banks has been to flood the financial market with liquidity. This is adding fuel to the inflation fire. The current money stock is inflationary. Adding more money only accelerates inflation. The excess money supply is piling up in markets where demand is strong but supply is tight - like oil. As these commodities inflate, wages follow. Through wage increases, all the excess money supply eventually becomes inflation. This reality cannot be changed by anyone's rhetoric. Inflation can only be stalled by aggressively cutting money supply, which means a deep recession that central banks still cannot accept.

Stagflation has arrived. Surging oil prices and unemployment symbolise its arrival. Coping with stagflation is the most important factor in investment success over the next two years. Even though property is a traditional hedge against inflation, it won't work this time because prices have inflated before and demand is worst affected by the credit crisis. Hong Kong is a typical place where property's inflation hedging nature is misunderstood. As soon as you land in Hong Kong, someone whispers "negative real interest rates - buy property". But that totally disregards the current overvaluation and the deteriorating income challenge.

Bonds are still priced as they were during the low inflation era and may suffer a massive downward repricing of more than 30 per cent. Economic deceleration makes credits and stocks vulnerable. Neither is cheap to begin with. Energy, industrial commodities and precious metals continue to benefit from negative real interest rates but may suffer a sharp reversal due to speculative overshooting and central bank pressure. Cash is losing value as inflation is higher than interest rates. For investors, it looks like a lose-lose world.

Today's world is especially treacherous for central banks with large foreign exchange reserves. China, Russia and Saudi Arabia have earned enormous amounts over the past five years and stashed the money mostly in the US treasuries. They could suffer catastrophic losses if the treasuries are repriced. The 10-year treasury is yielding 4 per cent, against 4.1 per cent inflation in the US last year, and probably higher this year. The market still doesn't believe the current inflation rate will stick. When it wakes up to the inflation reality, the 10-year treasury may yield over 6 per cent and its nominal value could decline by 40 per cent. European and Japanese bonds may have less downside than the US treasuries but they are also vulnerable to repricing. Selling bonds is probably the most important decision in managing foreign exchange reserves today.

The only large enough and liquid enough alternative to bonds for foreign exchange reserves is stocks. But stocks, priced at 2.3 times book value, are not cheap. As market expectations build of a global recession next year, stocks could suffer a 20 per cent decline and considerably more for some speculative emerging markets. However, the decline is cyclical. When the global economy picks up, possibly in the second half of 2010, stocks will recover above the current price. But bonds won't. Hence, foreign exchange reserves should shift from bonds to stocks over the next 12 months. As foreign exchange reserves are so vast, index funds are probably the most practical instrument for the switch.

Commodities, while highly volatile, may perform well over the next 12 months, as central banks stall on raising interest rates. In the second half of next year, the hope that inflation will come down on its own may vanish, and central banks could be forced to raise interest rates aggressively to remove negative real interest rates. Commodities may tumble. While gold and oil are still hot, play with caution.

Cash is bad but perhaps not as bad as other asset classes. If negative real interest rates are 2 per cent to 3 per cent, holding cash may lose you 7 per cent to 10 per cent over a three-year period, probably less than most asset classes.

It seems unfair that it's so hard not to lose money. Good old cash has also become a hot potato. But this is the price to pay for non-stop parties over the past 10 years. It's a lose-lose situation. But you can choose to lose the least.

Andy Xie is an independent economist