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The aggressive reflationary monetary strategies currently being pursued by major governments globally are likely to result in higher inflation in many economies in the immediate future, which investors will need to take into account, says Yu-Ming Wang, Nikko AM’s chief investment officer – international.

Nikko AM is a leading Asian-based asset management company, with approximately $A149 billion in funds under management (as at 31 December 2012).  It is represented in Australia by Tyndall Investment Management (Tyndall AM).

In his paper Re-emergence of Inflation Expectations in Asia, Mr Wang says that these monetary strategies could present an inherent risk to investors, but also offer an opportunity for future gains through careful portfolio rebalancing.

“We believe that there are several indications that higher inflation expectations are in the early stages of taking hold in the asset markets’ discounting mechanisms.

“The most compelling of these is the publicly stated inflation-targeting policy being pursued by the US Federal Reserve and the Bank of Japan (BOJ). This is a huge policy change for the BOJ, which could unleash a new wave of liquidity into global financial markets.

“Central bankers around the world have been busy fighting against deflationary risks resulting from the aftermath of the 2008 global financial crisis, with many using quantitative easing (QE).

“In general, QE has succeeded in its purpose of stabilising confidence and preventing a downward deflationary spiral.

The fact is that the money injected into the global economy by central banks has been sitting idle in the form of cash held by corporations or financial institutions. Loan demand has dwindled and currently companies have little incentive to invest. In this type of environment, inflation does not have much chance of taking a firm hold,” the paper says.

However, Mr Wang points out in the paper that recent developments in monetary policy may change things.

“The US Federal Reserve has embarked on a new policy under the banner of “inflation targeting”, which simply means that QE can stay open-ended, in terms of quantity and duration, as long as inflation stays below target.

“This new and aggressive monetary stance is being echoed in Japan, as the new administration blames the weak BOJ monetary stance for the persistently deflationary forces in the shrinking economy.

“Many investors, including Japanese ones, remain sceptical that inflationary expectations will rise, but a major structural change is now happening at the BOJ since a new Governor will be appointed soon for a five-year term. This will cause monetary policy to be much more aggressive in the long term.

“Moreover, the Abe administration has much firmer foundations than the previous five governments, so its reflationary policies will likely be long-lasting. As a result, we expect inflationary expectations to rise in Japan up to the BOJ’s new 2% inflation target level. Since Japan is a very significant economy with large quantities of savings, this will have a major effect on global inflationary expectations.

“We believe that investors have many reasons to pay attention to this trend. If Japan is even halfway successful in achieving its reflationary goal, the implications for investors’ future purchasing power and capital markets’ valuation levels will be powerful and long lasting.

“To manage this, investors will need to turn to strategies that have not been required in recent years.

“Classic inflation hedging strategies used to focus on gold, commodities and equity investing, but we believe that following this mindset in asset allocation strategies is outdated. Today’s investors, who are typically closer to their retirement phase, mostly have a lower tolerance for risk and a greater need for reliable cash flows, as their investment time horizon is much shorter.

“Fortunately, there are other tools available that may protect investors from the potential erosion of future inflation on net assets.”

The paper points to certain bond investing strategies which can still perform well in a rising inflationary environment, including: credit and short-duration strategies; inflation-linked and floating-rate bonds; and convertible bonds.

“Investing in local currency bonds can be another strategic option to mitigate downside risk to bond prices in an inflationary environment. Holding fixed income securities denominated in currencies with positive fundamentals can offer additional returns from foreign exchange (FX) appreciation.

“In addition, history has shown that equity markets can provide a decent hedge against inflation threats over the long term.

“Furthermore, investing in stocks that offer high dividends can provide another shield against inflation. After collecting the dividend payouts, an investor still retains the ownership of stock in an ongoing business that could grow. Future dividend payouts could therefore grow along with inflation, protecting purchasing power.

“However, investors should be careful not to put too many eggs in one basket (in this case, energy resources) to benefit from rising inflation expectations. Rather, a diversified approach should be maintained, not just within commodity investing, but also among different asset classes.

“By taking a longer-term view, evaluating the risks and rewards of individual sectors and with careful consideration of fundamentals, investors with a multi asset-class inflation-hedged portfolio will very likely benefit from higher inflation expectations,” the paper concludes.

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 6 March 2013