Effects of inflation on asset allocation

The discussion on asset allocation has led us to an important topic
of inflation. I feel that inflation deserves a more detailed analysis
because of the complicated ways in which it affects businesses. I'll
try to explain this in this message.

During inflationary period the currency loses value which cause all
the securities denominated in that currency lose value. In case of
long term debt the impact may be even higher because the central
banks resort to increase in interest rates to check the inflation
which depresses bond prices.

The real assets like properties, plants etc are less vulnerable to
inflation because their nominal values rise along with inflation.
However the impact is not straightforward and can be detrimental to
the business in many ways.

EFFECT OF INFLATION OF BUSINESS

Let's enumerate the beneficial effects of inflation on business.
B1) Inflation tends to increase the prices of assets like real
estate, plant and machinery etc which directly adds to the nominal
value of existing stock of capital.
B2) The rising asset prices make affect the supply of new investments
because rise in supply price. For example the increase in steel
prices would mean higher cost of setting up a plant which may or may
not provide enough returns to justify cost. This increases the
competitiveness of existing asset base.
B3) The fall in the value of currency decreases the indebtedness of
the company. If a company has taken a loan of Rs. 500 crs, the fall
in the real value of rupee will mean that the company can pay back
with less amount of real currency.

Let's enumerate the detrimental effects of inflation on business
D1) Inflation affects the consumer demand because of increased cost
of living which may not be offset by a rise in monetary wages.
D2) Any increase in monetary wages due to inflation can lead to rise
in operating cost which is risky because monetary wages tend to be
sticky and may not decline as situations change.
D3) Inflation increases the working capital requirements to manage
the same level of output. This affects working capital intensive
businesses like retail in a big way. This effect was explained by
Buffett in his letters to shareholders during inflationary period of
early 80's.
D4) In a competitive environment the businesses may not be able to
pass costs to the consumers. For example biscuit manufactures in
India have not been able to increase prices since last 6 years even
though the input costs have risen by more than 505 in the same period.
D5) If Central banks raise the interest rates the valuations based on
discounted cash flow suffer due to rise in risk free rates.
D6) The destabilization of economic system due to high inflation
leads to rise in risk premium.
D7) Although the nominal values of assets like real estate, plant and
machinery rises with inflation, the values of other assets like
cash, investment by company in bonds etc decline. (related to B3)

EFFECT OF INFLATION OF ASSET PRICES

The asset prices react in different ways to the rise in inflations.
1. The hard cash has permanent loss equivalent to the inflation rate
2. Bonds may be affected more due to compounded effects of high
maturity and rising in interest rates. However there is a twist to
this. If the interest rates have already moved higher with inflation
and fall along with subsequent fall in inflations bonds may provide
higher returns considering the risk involved.
3. Stocks are the least affected in general. However the prices do
not always rise with rising inflation. The inflationary period due to
oil shock, in late 70's and early 80's in US, is a testimony
to this.
Between 1964 and 1981, Dow Jones remained at the same level i.e 875
because the Fed raised interest rates from over 4% at year-end 1964
to more than 15% by late 1981. A seventeen year bond bought in 1964
would have given a return of 4%. Similar observations
can be noted by comparing the performance of Indian equities in early
90's and govt. securities.

Higher inflation is typically a characteristic of over heated economy
which is associated with surplus liquidity, investment boom and low
interest rates. In such cases the overriding optimism and shift to
equities often results in high stock prices. As the effects of
inflations may not be all in favor of the business such high prices
may prove to be a temporary phenomenon.

4. If the conditions of runway inflation the real value of bonds and
cash would be almost wiped out as happened after breakup of USSR with
inflation crossing 1000% per year.

CONSLUSION

A general conclusion can be derived that equities, bought at fair
prices, are the best bet when you expect higher inflation. If the
inflation has already moved high the low bond prices may be more
attractive choice as inflated stock prices. The investor is faced
with a difficult choice of slow erosion of real value through
investment in debt on one hand and prospect of decline in asset
prices from current highs on the other. Like all another financial
situations, he need deal inflationary conditions with caution and he
should base his actions on his knowledge and understanding of current
situation.


Posted: Dec 13,2004
http://in.groups.yahoo.com/group/lawarrenbuffet/message/1119