Inflation seen lurking in the wings

Reports of the demise of inflation have been grossly exaggerated, according to one of Canada’s most prominent market commentators. In fact, Gavin Graham, chief investment officer at Guardian Group of Funds, says the real low inflation environment ended in 2001.

At first blush, this seems to be at odds with official reports on inflation, as provided by StatsCan. In February, inflation reportedly dropped to an annualized rate of 2.2%, which is regarded as relatively benign, after the rate hit 2.8% in January.

“Inflation is returning,” Graham says. “The fall in inflation that we have seen in the past 20 years came to an end somewhere around 2000. Although there is still deflation in traded goods, thanks to the supply from Asia’s emerging markets, we are already seeing it in areas such as services and particularly commodities.”

The run-up in commodity prices is about the worst kept secret in the Canadian market, having driven the S&P/TSX Composite Index to double digit gains with soaring oil and mineral prices. That’s the upside. Eventually inflation in the cost of inputs will have to feed through the system and will find its way to the consumer.

While Graham is not predicting a return to the bad old days of 8% inflation, he does think that Canadian investors may have become too comfortable with low inflation, and may have forgotten how easily it can erode wealth.

To protect their purchasing power, investors should be seeking higher returns, which can be done, he says, while reducing overall volatility.

“Ironically, investors have been redeeming their U.S. and global equity funds over the last two years, partially owing to the strength of the Canadian dollar,” Graham said. “GGOF feels that global investing has a place in every investor’s portfolio, both for reasons of diversification and for lowering volatility by accessing other economies.”

In a conference call hosted by GGOF, Graham assembled the three external managers of the GGOF Global Diversified Fund, who remain bullish on both commodities and Asian investment.

There are the obvious high-growth economies, such as China, India and South Korea, but lately, even Japan has been showing signs of recovering from its decade of despair. And with its world class companies, the Japanese market shores up the more volatile region quite nicely, according to Mark Headley of Matthews International Capital Management.

“There are signs [in Japan] of a returning inflationary environment, which really has been the primary driven of the equity markets in the past two years,” says Headley. “Growth across Japan has been robust and nine years of deflation seem to be coming to an end.

“This is really the icing on the cake for the Asia-Pacific environment where China has been rowing along for many years now and India has really hit its stride as a growth environment.”

Asia’s phenomenal growth has been the driver of the global commodity rally, which has benefited few countries to the same extent as it has Canada. While demand has soared, there has been little reinvestment in the sector in terms of increasing production, according to Matt Haynes of Lazard Asset Management.

“One of the great opportunities for alpha creation is going to be in the mining space in general,” Haynes says. “A lot of the focus to date has been on the demand side of the equation, but what has been ignored is the fact that the supply situation has been static for the past 20 to 25 years.”

He says that copper has historically been an accurate indicator of inflation and that current prices are pointing to higher inflation.

“We’re secular bulls on zinc, copper and nickel; all commodities in general are going to be experiencing increasing price pressure because of the supply and demand characteristics,” Haynes says.

Another sign that commodities will remain strong is the development of large scale reclamation facilities, such as a new smelter in British Columbia designed to extract base metals from discarded computer hardware.

“We’re seeing basic material prices — input prices — rising significantly, whether they be base metals or energy,” Bruce Jackson of Barrantagh Investment Management. “What we try to focus on are the companies that are the best run in those industries.”

He says resource companies can be their own worst enemies, as they scramble to build out production capacity at a time when the cost of doing so is at its highest. While they benefit from the high price of the commodity they produce, building new capacity requires a great quantity of expensive resources.

“We are susceptible to a little bit of catch-up in inflation,” says Jackson. “It could show its ugly head at any time.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(03/20/06)

Steven Lamb

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