How To Inflation, Deflation and Investment Decision

[i n india]

The Investment decision for an individual or an organization is largely determined by the prospects for Inflation or Deflation in the near future. One of the prime objectives of investment is to beat the rate of inflation so that the purchasing power of an individual remains the same or increases over a period of time.

A very simple example would illustrate why it is important to check for returns adjusted for inflation and hence make investment decisions accordingly.

Suppose a person has INR 100 to invest. He/She selects a one year bank Fixed Deposit as an investment option which would give the individual a return of 8%. At the same time let us assume that the rate of inflation is 10%.

So after one year the individual gets back INR 108 (INR 100 principal and INR 8 as interest).

However, during the same one year period, assuming a 10% inflation, the cost of goods and services would be up from INR 100 to INR 110.

Thus, the individual can buy less of goods and services a year later (loss of purchasing power) due to the fact that his/her investment did'nt beat the rate of inflation.

What is Inflation

In order to make wise investment decisions, one needs to clearly understand what inflation means.

Inflation can be considered as the increase in money supply in the system.

Inflation for an induvidual would however be the yearly increase in price of goods and services he/she uses.

In this respect I would like to add that one should not go by the Government numbers for inflation. It is best to do a rough calculation for inflation by oneself. The reason is that the Government always understates the inflation numbers.

In U.S.A., core inflation is targetted (which excludes energy and food). I am sure no American lives without energy and food. So this kind of inflation numbers make no sense.

In India, the RBI uses the WPI to make interest rate decisions. However, the WPI is overweight on industrial commodities and crude oil. I am also sure that people don't need industrial commodities for their daily needs. In India, the RBI also publishes the CPI which is running at close to 12% as against WPI numbers of 0.4%. For consumers CPI makes more sense then the WPI.

So before taking any investment decision it is important to judge the amount of annual inflation that the household has to to bear.

Inflation and Investment Decision

I would first take up the case of inflation and how one needs to make investment decisions during times of inflation. I would be talking more about investment in times of inflation as my personal opinion is that we will see much higher inflation in the next 3-5 years. I have to add that a large part of this inflation expectation is from the flooding of liquidity in the system by the Governments around the world.

Before I talk about investments which would be good in times of inflation, it is also important to mention that even in times of high inflation some sectors of the economy might experience deflation or no price changes. This can be due to technological advancement and also do to a very favorable demand supply scenario.

The objective of telling this is to let investors know that it should not be assumed that in times of inflation everything will go up. I must admit that during the last bull run (2003- early 2008) almost all asset classes went up. But it need not be the same everytime and will not be the same this time in my opinion.

My view is that the real economy is very weak (and will remain weak) for a relatively longer period of time. This is more true for the U.S. then most Asian countries (taking a call on the Chinese economy is a difficult thing at this point of of time). So as the economy is not strong to absorb the excess liquidity in the system, the excess liquidity will go into asset classes like equities and commodities.

This will drive commodity prices and hence commodity stocks higher.

When the Indian markets crashed post January 2008, all stocks went down except commodity related stocks. The commodity related stocks fell only after July 2008, when the commodity prices peaked out. Thus, the equity markets were falling broadly but some segments of the markets were still going up. If one believes that industrial commodities will again go higher in the next 2-3 years, then the following are some of the best places to remain invested in (in my opinion):

1) Industrial Commodities

2) Industrial Commodity related Stocks

3) Gold and Other Precious Metals

4) Crude Oil and Natural Gas

5) Mining Companies

At the same time, if my expectation is of a industrial commodity lead inflation, then I would avoid or be underweight on the following sectors:

1) Infrastructure and

2) Any other major Commodity consumer (Example: Automobile Sector)

This does not mean that these sectors might not do well in the next 2-3 years. But if commodity prices surge, then the commodity consumers (in general) would not do as well as the Commodity producers.

Some of the specific stocks/ETF/Funds I would be interested in would be:

1) Sterlite Industries Ltd.

2) Oil and Natural Gas Corporation of India

3) Gold ETF's and some physical Gold and Silver

4) DSP Blackrock World Gold Fund

5) Fund that only Invests in Natural Resource Companies

Deflation and Investment Decision

It is relatively easier to make an investment decision when we are talking about deflation. Again, deflation might happen in just some sectors of the economy with others experiencing inflation. But what would be the best investment if all asset classes are falling?

In such a scenario Cash is the best investment.

A simple example would make my point more clear:

Let us assume that all asset classes are falling (like it had happened after the collpase of Lehmann Brothers). Also suppose that an investor has INR 100 with him when the price of one share of Company X is Rs. 100. But as all prices are falling the stock price of the Company goes down to INR 50.

Thus, with the same cash one can now buy 2 share of Company X when earlier the investors was able to buy only 1 stock of the Company.

So in a scenario where all asset classes are going down in value, it is cash which is actually going up in value.

But as I said, this happens rarely and thus one needs to focus more on investment strategies at times of inflation.

Is Fixed Deposit a Bad Investment

I had mentioned earlier that if one is getting only 8 or 10% per annum in a FD when inflation is well over 10% then it makes no sense to invest in such a instrument. But one needs to diversify risk to some extent. In this context, investing a small amount of money where one can expect fixed returns is not a bad idea. The only thing is that the allocation should be relatively small.

Everyone needs to realise that in times of high inflation keeping money just in hand or bank is a bad idea. Money needs to be put to work in order to mantain purchasing power by beating the rate of inflation.