Prepare portfolio for inflation now: CIBC

Investors should start building themselves a buffer against inflation, increasing their exposure to precious metals and building a cash reserve before interest rates rise, according to a report out of CIBC World Markets.

“Investors are likely underestimating just how much (interest) rates will rise over the next 18 months,” write Peter Buchanan and Meny Grauman, senior economists, in the latest Canadian Portfolio Strategy Outlook.

Buchanan and Grauman predict that 12 months from now interest rates will be 100 bps higher and the price of oil will have long since resumed its upward movement.

The pair says that inflation south of the border is currently at 17-year highs, leaving little option for central bankers but to raise rates. Until now, America’s Federal Reserve has been reluctant to do so, as it would throttle an already wheezing economy.

Investors should expect rate hikes to follow November’s presidential election and continue through 2009. The Fed is expected to raise its trend-setting rate by as much as 200 bps.

Such a large increase would be hard for Bank of Canada governor Mark Carney to ignore, even as the Canadian economy slows.

Higher interest rates and a slower economy will not dampen the price of oil, however, as subsidized fuel prices in emerging economies will prop up demand, and therefore the price, even as U.S. demand falls. In the first half of 2008, U.S. consumption fell by 500,000 barrels per day.

“The past year’s drop in crude demand is just a quarter of the reduction that will be needed over the next five years to free capacity to fill the gas tanks of millions of new motorists in places like China and India,” says Buchanan. “That adjustment is unlikely to occur without even higher crude prices.”

With these predictions in place, the CIBC World Markets team has updated its Strategy Portfolio, shifting a percentage point out of base metals to precious metals, as an inflation hedge.

“Gold bullion is a traditional inflation hedge, and our analysis indicates the same holds for Canadian gold and silver mining stocks,” says Buchanan. “In the absence of a sizeable move up or down in the U.S. dollar, we expect changes in inflation to be the main force affecting bullion prices over the balance of 2008.”

To mitigate the impact of higher interest rates, the portfolio’s bond allocation will be trimmed by one percentage point, which will be allocated to cash.

The portfolio maintains its market-weight allocation to equities in general and remains overweight in energy and materials. The target price for oil is unchanged, at $125 per barrel for 2008 and $150 per barrel in 2009.

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

(08/08/08)