inflation why to worry or not

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Private Wealth Management Deutsche Bank Inflation: Why Worry, Why Not to Worry, and What to do if You‘re Worried Marshall Gittler Chief Strategist, EMEA Place des Bergues 3 CH-1211 Geneve 1 Switzerland [email protected] +41 (0) 22 739 0463 May, 2011

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A presentation I did on how to protect portfolios against inflation

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Page 1: Inflation   Why To Worry Or Not

Private Wealth ManagementDeutsche Bank

Inflation: Why Worry, Why Not to Worry, and What to do if You‘re Worried

Marshall Gittler

Chief Strategist, EMEA

Place des Bergues 3

CH-1211 Geneve 1

Switzerland

[email protected]

+41 (0) 22 739 0463

May, 2011

Page 2: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 2

Hyperinflation Deflation

Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions

Inflation: Why WorryCentral banks‘ real policy rates at or below zero

— Central banks around the world sharply reduced their policy rates in response to the 2008 financial crisis, in

many cases to zero. After taking inflation into account, the real policy rate is at or below zero in most

regions except for Latin America.

Page 3: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 3

Hyperinflation Deflation

Source: Bloomberg Financial LP, Bank of Japan, Bank of England, Swiss National Bank, Deutsche Bank Global Investment Solutions

Inflation: Why Worry Major central banks expand their balance sheets

— In addition to reducing the price of money, central banks have been aggressively increasing the quantity of

money available by pumping up their balance sheets. This increases the supply of reserves that banks hold,

which eventually should increase the amount of bank loans and hence the supply of money.

Page 4: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 4

Hyperinflation Deflation

Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions

Inflation: Why Worry Narrow money supply is rising, broad money just starting

— The growth in narrow monetary aggregates, which the central banks control, came down sharply after its 2009 spike, but

has started to recover again.

— The broad aggregates – which the market controls – have also been recovering since the beginning of last year, but are

still well behaved. Large-scale inflation is not likely unless these broader aggregates start to rise sharply as well.

Page 5: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 5

Monetary base and M2 in the US and Eurozone

Source: Fed, ECB, Deutsche Bank Global Markets

— We can see this difference particularly in the US and in Europe. The monetary base (MB), which consists of banks‘

reserves at the central bank and cash in the hands of the public, has soared because of the extraordinary

―quantitative easing‖ in which central banks buy bonds from the market, However growth in the broader aggregates,

which represent money available for spending, is still relatively tame.

— In the US, M2 is defined as M0 (bank reserves at the central bank plus notes and coins in circulation) plus deposits in checking accounts (M1) plus

money in savings accounts, certificates of deposit up to $100k, and money market accounts. In Europe, the European Central Bank defines M2 as

M0 plus overnight deposits, deposits with maturities of up to two years, and deposits redeemable with notice of up to three months.

Inflation: Why Worry Narrow money supply is rising, broad money just starting

Page 6: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 6

Hyperinflation Deflation

Inflation: Why Worry Inflation has followed broad money growth in US

Broad money growth and inflation over time in the US

— What would happen if broader monetary aggregates start to rise more rapidly? The relationship between the

rate of growth in broad money and the rate of inflation in the US is well established over long time horizons.

Page 7: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 7

Hyperinflation Deflation

Inflation: Why Worry The same relationship holds across countries

Broad money growth vs inflation in several countries

Source: iMF, OECD, Deutsche Bank Global Markets

— This relationship is not unique to the US. It also holds in a wide variety of countries.

Page 8: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 8

Hyperinflation Deflation

Source: Deutsche Bank Global Markets Research

US and UK inflation, 1750~present

Inflation: Why Worry Inflation is also a fiscal phenomenon, not just monetary

— Inflation is not just a monetary phenomenon. Historically, when governments have run up big debts (usually

due to wars), they have resorted to inflation in order to diminish the burden of paying back that debt.

-10

-5

0

5

10

15

1750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000

US UK

Consumer price inflation (% yoy, 11 year ma)

Napoleonic wars:

deficit monetised

1st industrial revolution:

productivity-led deflation

2nd industrial revolution:

productivity rebound;

gold f inds

Fiscal monetisation

during WWIFiscal monetisation

during WWII

Fiscal monetisation

during Vietnam War;

oil shocks

Volcker

clamps

down on

inflation

Depression

US civil warUS war of

independence

Page 9: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 9

Source: C. Reinhart and M. Sbrancia, “The Liquidation of Government Debt,” Peterson Institute for International Economics WP 11-10

1. Economic growth

2. Substantive fiscal adjustment/austerity plans

3. Explicit default or restructuring of debts

4. A sudden surprise burst in inflation

5. A steady dosage of financial repression that is

accompanied by an equally steady dosage of inflation

Inflation: Why Worry How debt/GDP ratios have been reduced in the past

Page 10: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 10

The US govt engineered negative real rates to reduce its debt

— The US had significant debts left after WWII.

Strong growth helped to reduce these debts, but

financial repression also played its part.

— Financial repression included:

— Interest rate ceilings on deposits, which

induced investors to hold govt bonds.

— Regulations to ensure that govt debt played

a dominant role in domestic institutions‘

asset holdings, particularly pension funds

— High reserve requirements for banks

— Restrictions on the international movement

of capital and on gold holdings

— Overall, low nominal interest rates

(below nominal GDP growth) and

inflationary spurts resulted in negative

real interest rates

Inflation: Why WorryFinancial repression and the US post-WWII debt

Source: C. Reinhart and M. Sbrancia, “The Liquidation of Government Debt,” Peterson Institute for International Economics WP 11-10

Page 11: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 11

Hyperinflation Deflation

Inflation: Why Worry Inflation is politically easier than taxation

Only in taxation do people discern the

arbitrary incursions of the state; the

movement of prices, on the other hand,

seems to them sometimes the outcome of

traders’ sordid machinations, more often a

dispensation which, like frost and hail,

mankind must simply accept. The

statesman’s opportunity lies in appreciating

this mental disposition.

Friedrich Bendixen, German economist

and banker (1864~1920)

Source: Robert Hetzel, “German Monetary History in the First Half of the Twentieth Century”

Source for photo: Wikipedia

Page 12: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 12

Hyperinflation Deflation

UK price index through the ages (log scale)

Inflation: Why Worry Fiat money makes it easier to create inflation

Source: SG Securities,, “Popular Delusions,” 27 May 2010

— Don‘t think that modern

central banking will

prevent a reoccurrence

of this phenomenon. On

the contrary, modern

central banking and the

invention of fiat money

(as opposed to money

backed by precious

metals( has made it

easier for central banks

to debase the currency.

— If we look at Great

Britain, prices rose 10x

in the 600 years from

1300 to 1900. They rose

100x in the following

century, and most of that

has occurred just in the

last 65 years since

WWII.

Page 13: Inflation   Why To Worry Or Not

Inflation: Why Worry Government monetization of debt causes hyperinflation

13

Weimar inflation caused by soaring monetary base

Notes: Data normalized with 1913 equal to 1. Observations are the natural logarithm. The

monetary base is cash in circulation plus commercial bank deposits at the Reichsbank.

Source: Robert Hetzel, “German Monetary History in the First Half of the Twentieth Century”

Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions

Argentina did the same more recently

— From the end of WWI to 1924, the price level in

Germany rose by almost 1trn times.

— In 1913, total currency in Germany was 6bn marks.

Ten years later, a loaf of bread cost 428bn marks.

— The cause of this inflation was monetization of debt

by the central bank, the Reichsbank.

— Argentinian inflation, already running at 500% a year

by 1989, soared to 20,000% by 1990 as the

monetary base rose 12,726% a year at its peak in

early 1990.

— Something that cost 1 cent in Jan 1988 cost $76 just

four years later.

Page 14: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 14

Inflation and external default 1900~2006

Source: Reinhart and Rogoff, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” http://www.nber.org/papers/w13882.pdf?new_window=1

Inflation: Why WorryBanking crises often result in inflation as well

— A banking crisis is typically followed by external default. External default is typically followed by inflation.

Page 15: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 15

Government changes in calculation method reduce stated inflation rate

Source: Courtesy of www.shadowstats.com

— The US government has

changed the way it calculates

the inflation rate 24 times since

1978.

— If it were still calculated the

same way it was done in 1980,

it would be closer to 10%.

— Technological improvements

help to hold down the rate of

inflation, but you can‘t eat an

iPad.

Inflation: Why WorryWhat is the actual inflation rate?

Page 16: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 16

DB Global Markets model of inflation based on economists‘ forecasts

Source: BLS, Eurostat,, Deutsche Bank Global Markets

— Economists are not looking for a major rise in inflation. A model of inflation that uses the year-ahead forecasts

of inflation based on the Survey of Professional Forecasters suggests that inflation is likely to accelerate but

remain below 2% next year in both the US and the Eurozone.

Inflation: Why Not to Worry Economists are not looking for rapid inflation

Page 17: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 17

Rates soared in Argentina…

Inflation: Why Not to Worry Difference between then and now: the demand for money

…but have collapsed recently

Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions

— This time around however interest rates have fallen

even as central bank balance sheets have doubled.

— While the supply of money is soaring, the demand is

collapsing. Thus the price is also falling.

— As the money supply soared in Argentina, interest

rates soared too, with 1~2 month deposit rates

reaching 1,650% a year in 1989 (when inflation was

1,233%).

— The market broke down completely for a time in

1990 as inflation soared to over 20,000% a year.

Page 18: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 18

The composition of the private sector‘s balance sheet changes, not its size

Inflation: Why Not to Worry QE does not actually increase the supply of money

Before Fed buys bonds from the market

Reserves 50 Deposits 100 T-bills 50 Reserves 50 Money 45 T-bills 50

Loans 20 Capital 10 T-bonds 0 Public goods 45 T-bonds 40

T-bonds 40

After Fed buys bonds from the market

Reserves 90 Deposits 100 T-bills 50 Reserves 90 Money 45 T-bills 50

Loans 20 Capital 10 T-bonds 40 Public goods 45 T-bonds 40

T-bonds 0

Bank ABC

Bank ABC

Fed

Fed

Treasury

Treasury

Source: Deutsche Bank Global Investment Solutions

— Quantitative easing does not cause any change in the size of the private sector‘s balance sheet, only the

composition. It exchanges interest-bearing bonds for non-interest-bearing reserves. So in fact QE may be a net

drain on the private sector‘s funds (in that it reduces interest income).

— The Fed‘s balance sheet does expand, as does the composition. But it is not new money being injected into the

private sector; it is merely being swapped for an asset that was previously created (and the money already

spent by the government). So net financial assets do not change.

— There is no effect on the Treasury‘s balance sheet.

— The duration of the publicly held bond market is changed.

Page 19: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 19

DB inflation forecasts

Source: Deutsche Bank Global Markets

— We expect inflation to remain under control in the developed economies. While it might rise slightly above the

Fed‘s 2% target in 2011 and 2012, we expect this will be largely due to energy and commodities – underlying

inflation should remain under control.

— In the emerging market countries, we expect inflation to come down in Asia in the second half of the year and

for inflation in all regions to be lower in 2012 than in 2011.

Inflation: Why Not to Worry We expect only modest inflation in the developed world

Page 20: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 20

Food inflation peaking Money supply growth has slowed

Source: Bloomberg Financial LP, Deutsche Bank Global Investment Solutions

— Money supply growth has also come down sharply

over the last several months under government

pressure.

— The lagged effect of these efforts should help to

bring down the rate of inflation as well.

— Rising inflation in China has been driven mostly by

higher food prices.

— However, food prices have come down in the last

few weeks, leading us to expect that inflation is

likely to peak in the next few months and fall in the

second half of the year.

Inflation: Why Not to Worry Chinese inflation likely to slow in 2H

Page 21: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 21

Hyperinflation Deflation

Value of money under various inflation regimes

Inflation: Why WorryNonetheless, even low inflation has a big impact over time

Source: Deutsche Bank Global Investment Solutions

— Nonetheless, it doesn‘t require hyperinflation to make a dent in the value of your portfolio over time. Even small

levels of inflation will slowly eat away at the real value of your assets.

— For example, with 1% inflation you effectively have only 90% of your money left after 10 years. If the inflation rate

rises to 3% -- not that high, really – the amount would be reduced to 74% after 10 years.

— And at that rate, after 50 years the real value of your assets would be worth only 22% of what they were at the

beginning. The central bank would have taken 80% of your money away, bit by bit, without your hardly noticing it.

Page 22: Inflation   Why To Worry Or Not

Inflation: What To Do About It if You‗re WorriedNature of the two types of inflation

22

Correlation between growth and inflation Expected vs unexpected inflation

— Growth and inflation are typically positively

correlated. During such times, risky assets can

perform well.

— However the correlation does not always hold.

Sometimes there is stagflation, sometimes

inflation falls even as growth accelerates.

— The main risk to a portfolio is from inflation

shocks or ―unexpected inflation,‖ which can

change‘ views on the relative merits of

different asset classes and change discount

rates. There is little correlation between

expected and unexpected inflation.Source: Deutsche Bank Global Markets Research

Page 23: Inflation   Why To Worry Or Not

Inflation: What To Do About It if You‗re Worried Impact on assets of an inflationary shock

23

Inflation shock elasticities*

Years after the inflationary shock

*Defined as the percent change in the asset class total return or price index divided by the

percent change in inflation. An inflationary shock is defined as a one standard deviation

change in the month-on-month rate of inflation (0.2 percentage points).

1Source: Roache, Shaun K. K. and Attie, Alexander P., Inflation Hedging for Long-Term Investors (April

2009). IMF Working Papers, Vol. , pp. 1-37, 2009. Available at SSRN: http://ssrn.com/abstract=1394810

— According to an IMF study1, the response of different asset

classes to inflation varies over time. This means that the

optimum portfolio in response to rising inflation must be

rebalanced dynamically as the economy and markets

adjust to the change.

— By asset class, the results of the IMF study were:

— Cash: Cash returns increase with inflation, but the response

is gradual and less than complete. Over the long run, cash

has not fully compensated for the increase in prices. That

could be different in the future if central banks take a more

active stance against inflation.

— Bonds: Long-term bonds are the worst performing asset

immediately following an inflation shock as yields increase.

After about three years though, the dynamics gradually move

in favor of long-term bonds as real yields rise.

— Equities: Equities have not protected against inflation in the

long run. Equity returns decline immediately after an inflation

shock and do not recover meaningfully after that. This makes

them the worst performing asset class over the long run in

response to an inflationary shock. This is not to say that

equities underperform other traditional asset classes in real

terms over long horizons, just that they may not offer much

protection during periods of rising inflation.

— Commodities: Commodities have been the best performing

asset class when inflation was rising, but the long-term

effects of inflation cause commodity prices to fall gradually,

either because of rising real interest rates or slowing output.

— This study did not include real estate or index-linked bonds.

Page 24: Inflation   Why To Worry Or Not

Inflation: What To Do About It if You‗re Worried Equities are not as good an inflation hedge as believed

24

Equities vs unexpected inflation: negative

correlation Larger inflation shocks cause worse returns

Source: Deutsche Bank Global Markets Research. “Unexpected inflation” is defined as the difference

between 1yr ahead US inflation forecasts from the Survey of Professional Forecasters with realized yoy

inflation.

— Equities are not always a successful hedge

against unexpected inflation. In fact, there is a

negative correlation between unexpected inflation

and equities (i.e., the greater the unexpected

shock, the worse equities do.

— A little bit of inflation can be good for equities. The price/earnings

ratio (P/E) in the US has generally been highest when inflation is

1%~2%, followed by 2%~3% (the range that we expect).

— But as inflation climbs, forward P/E ratios start to decline. This is

because the company‘s real return on equity (ROE) falls as the

replacement cost of its assets rises and accounting depreciation

falls below replacement cost. Nominal returns rise, but real returns

fall. The market sees through this problem and assigns a lower P/E

ratio to stocks as inflation rises.

— But a moderate rise in inflation – as we expect -- tends to cap the

upside for stocks, rather than introducing any downside.

Page 25: Inflation   Why To Worry Or Not

Inflation: What To Do About It if You‗re Worried Commodities have hedged against unexpected inflation

25

Commodities vs unexpected inflation— The correlation between commodity

returns and inflation has been positive,

with high commodity returns associated

with high unexpected inflation.

— Of course, this correlation will hold when

inflation shocks result from high

commodity prices, as happened in the

1970s and some people fear may be

happening now. But the relationship

does not appear to be stable across

inflationary regimes.

— Commodity returns tend to be much

more volatile than inflation, making it

difficult to predict how the two will move

together.

Source: DB Global Markets Research

Page 26: Inflation   Why To Worry Or Not

Inflation: What To Do About It if You‗re WorriedProperty can hedge against inflation if rents can rise

26

Property vs unexpected inflation

Source: DB Global Markets Research, Bureau of Labor Statistics, US Census Bureau, Bloomberg

Finance L.P.

Total return on property = price return + rental yields – maintenance yield.

*1 Demary , Markus and Voigtlander, Michael, “The Inflation Hedging Properties of Real Estate: A

Comparison Between Direct Investments and Equity Returns,” Research center for Real Estate

Economics, Institut der deutschen Wirtschaft Koln, Germany. Available on the web at

http://eres2009.com/papers/5Dvoigtlaender.pdf

2Waggles, Doug and Johnson, Don, “An analysis of the impact of timberland, farmland and commercial

real estate in the asset allocation decisions of institutional investors ,” Review of Financial Economics,

Vol. 18, Issue 2, April 2009

— DB Global Markets‘ research has shown that property returns are

positively correlated with inflation, although the correlation is weak.

This suggests that property can be a partial hedge against inflation.

However property is illiquid and suffers from large transaction

costs.

— Other research1 has shown a difference based on the type of real

estate. Retail property tends not to provide good inflation

protection, because renters have a hard time passing along price

increases to customers and therefore landlords find it difficult to

raise rents.

— Offices on the other hand have provided protection against both

expected and unexpected inflation. Residential property was

even better, probably because home owners have market power

and can raise rents, given that there are few substitutes for

housing.

— Real estate equities however are no better than other kinds of

equities at protecting against inflation. On the contrary, the

correlation between real estate equities and inflation is negative.

This may be because interest rates tend to rise when inflation

rises.

— Another paper2 concluded that as acceptable risk levels rise,

timberland supplants commercial real estate as the primary

allocation to real estate in a diversified portfolio.

Page 27: Inflation   Why To Worry Or Not

Inflation: What To Do About It if You‗re WorriedIndex-linked bonds vs nominal bonds: a matter of timing

27

IL bonds outperform in unexpected inflation

Source: Deutsche Bank Global Markets, BoA/Merrill Lynch

— As mentioned earlier, long-term bonds are the worst

performing asset immediately following an inflation

shock as yields rise. Eventually though real yields rise

and nominal bonds begin to perform again.

— The graph shows that conventional bonds outperform

index-linked (IL) bonds when inflation is below

expectations, but IL bonds outperform when inflation is

above expectations.

— Over the last 13 years, there has been little cumulative

difference in the total return from the two. Long (5~10yr)

IL bonds have returned 146%, vs 149% for conventional

bonds, with nearly the same volatility of returns.

— The optimal strategy would be to move into IL bonds

early in the inflation cycle and shift back into nominal

bonds once real interest rates start to adjust.

— The current environment is one where actual inflation

has exceeded expectations and hence is a negative

inflationary surprise. Comparing our forecasts with the

market consensus, we expect inflation over the next two

years to be largely in line with market expectations and

therefore offer no further negative inflation surprise. We

therefore cannot recommend TIPS at this point.

— Developed economies issuing IL bonds:

— US, UK, France, Italy, Germany, Greece,

Japan, Sweden, Canada, Australia, Israel

— EM countries issuing IL bonds:

— Brazil, Mexico, South Africa, Turkey, Poland,

Chile, South Korea, Uruguay

Page 28: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 28

Hyperinflation Deflation

GIC recommended asset allocation (as of 26 April)

Inflation: What To Do About It if You‗re Worried Where to put your money: a diversified portfolio

Source: Deutsche Bank Private Wealth Management

— Given that there is not one

investment that can be

guaranteed to provide a positive

real return in an

inflationary/rising interest rate

environment, we believe the best

course of action is a diversified

portfolio.

— We present here our Global

Investment Committee‘s

recommended asset allocation

for the ―average‖ client.

— Of course, each investor has his

or her own needs and

preferences and so this general

portfolio would have to be

tailored to their specific

requirements.

Page 29: Inflation   Why To Worry Or Not

Private Wealth Management

Deutsche Bank Marshall Gittler

2011 Family Office & Wealth Management Conference 29

IMPORTANT NOTICE

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