Many investors—especially those who remember the recessions and stagflation (high inflation and low economic growth) of the mid-1970s—grow uneasy at the prospect of a new cycle of inflation and what it may mean for their investments. And telltale signs like higher oil and food prices, gold reaching new price plateaus, unprecedented new deficit spending by the federal government and an expansive monetary policy suggest there may at some point be cause for concern.

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Market outlook
Are inflation fears overblown?
Market outlook is a monthly publication to help inform your investment strategy July 2009
Many investors—especially those who remember the readily be met by rising output, rising demand will translate
recessions and stagflation (high inflation and low into inflation, although WMR doesn’t see the U.S. operating at
economic growth) of the mid-1970s—grow uneasy at full potential until the end of 2010 at the earliest.
the prospect of a new cycle of inflation and what it
may mean for their investments. And telltale signs like So what are investors to do right now? While there is no
higher oil and food prices, gold reaching new price perfect hedge against inflation, it would be prudent to
plateaus, unprecedented new deficit spending by the begin thinking about what impact inflation may have on
federal government and an expansive monetary policy their portfolios. It would be best to steer clear of certain
suggest there may at some point be cause for concern. investments and consider implementing others that could
help protect against and even potentially profit from
To combat the financial and liquidity crises, the Fed took structurally higher inflation in the long term.
action, starting about a year and a half ago, cutting interest
rates to near zero and engaging in what is called credit Floating-rate securities
easing, which is essentially the printing of new money and Central banks like the Fed typically hike interest rates
swapping it for longer-term financial assets. Sufficiently when they anticipate rising inflation. And higher interest
aggressive easing should flood the economy with new rates usually have negative consequences for fixed income
money, increase spending and support or even lift prices. Yet investments; already-issued ordinary bonds with fixed
if easing is too successful, undesirably high inflation could be coupons decline in value, since investors can receive a higher
generated over the medium to longer term. interest rate in the market compared to their bonds’ fixed
coupons. In contrast to fixed-rate bonds, however, investors
Another potential complication involves timing. While UBS may wish to consider bonds with interest rates that are reset
Wealth Management Research (WMR) thinks the Fed’s with changes in an underlying rate or index. (See chart on
measures will eventually succeed in pulling the U.S. economy the next page.) For example, CPI-linked bonds such as U.S.
out of recession, once that takes place, the problem will Treasury Inflation-Protected Securities (TIPS) will be reset with
switch from growth weakness to rising inflation. The Fed changes in the Consumer Price Index. Floating rate notes
must correctly time the move from expansive to restrictive (FRNs) issued by corporations will typically have their coupon
monetary policy in an effort to mop up the excess liquidity rates reset based on changes in the interest rate environment,
that was pumped into the economy, or the flood of fresh which may or may not be in line with actual inflation.
money could find its way into consumer or asset prices,
resulting in rising inflation. Foreign exchange
Inflation can do long-term damage to a currency. The law of
WMR believes inflation will likely be on average higher than one price, or purchasing power parity (PPP), says the inflation
the 3% we’ve seen over the past 25 years. Once the economy differential between countries must be compensated for with
operates at full potential again and additional demand can’t a devaluation of the currency with the higher inflation. In

2. Commodities
Inflation expectations in the U.S.
A sharp increase in U.S. liquidity has historically often produced
in %, calculated as the difference between yield a lagged price rally in commodities. Commodity markets with
on nominal and real inflation-linked bonds low spare capacity and high cyclical exposure—like oil, copper,
lead and tin—should do relatively well once demand recovers
on a broad scale and old supply constraints resurface. Even so,
WMR believes inflation alone is not a sufficient reason to buy
commodities, with the exception of certain precious metals.
The high industrial demand for platinum and palladium means
prices are sensitive to and fluctuate strongly with economic
swings. With gold, however, industrial demand is quite low,
around 20%, so it is less reactive to economic swings and
well suited to be an inflation hedge, says WMR. The price is
expected to test all-time highs, reaching $1,100 in the third
quarter of 2009, thanks to an onset of inflationary pressures
in the U.S., renewed U.S. dollar weakness and greater jewelry
demand in the second half of 2009, as retailers are forced to
restock their depleted inventories.
Real estate
During periods of high inflation, real estate prices have
historically generated a big increase in returns and largely
practice, this devaluation can take time, sometimes years.
preserved the purchasing power of the money initially
There are even cases where inflation weakens rather than
invested. WMR says real estate as a direct investment should
promotes appreciation pressure. In the U.S., the Fed has
still offer the best hedge against inflation in the long run,
embarked on credit easing which might lead to inflation
yet real estate equities and REITs perform similarly to normal
and a weakening effect on the dollar. Also, the market
equity markets, exposing investors to other, sometimes more
is likely to demand a higher risk premium for holding the
important, price drivers. Real estate funds appear to have
currency. WMR says investors should avoid probable high-
some inflation-hedging characteristics as they are generally
inflation currencies of the U.S. and the U.K., as they will likely
more exposed to residential properties. Still, WMR cautions
depreciate in value over time and increase their positions in
that the real estate sector is likely to remain in the doldrums
Asian countries, which appear attractive from their growth
for the foreseeable future and expectations of high inflation
and inflation perspectives.
should not be the sole driver behind a real estate investment.
Equities
For more information
Over the short term (less than a year), there’s generally a
To explore how some of the insights in this issue of Market
negative correlation between stock market returns and
Outlook might bear on your portfolio, please contact your
inflation. According to WMR, stocks are only effective hedges
Financial Advisor. For more detailed information on the above
against inflation if the investor has a short position. For the
article, please ask your Financial Advisor for copies of the
long run (over five years), however, the correlation is usually
following Wealth Management Research reports: Investment
positive. Overheating economic activity is typically followed by
Themes, “Long-term strategies to meet a surge in inflation,”
rising inflation, which coincides with stock market corrections,
June 25, 2009, and “Lower EM inflation now, but risks
as valuations become elevated and market participants start
loom,” June 22, 2009; Commodity Report, “Don’t get too
to anticipate a cyclical slowdown in growth. Investors are
negative on gold,” June 18, 2009; and the Economic Theme,
mainly concerned about the long-term consequences of losing
QE3: The longer-term implications,” June 4, 2009.
real wealth by structurally higher inflation rates, rather than
short-term cyclical swings, and WMR emphasizes the positive,
long-term relationship between stock returns and inflation.
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