I have looked into potential inflation hedges/speculative trades and decided to share some of my thoughts with the blog. Despite the rumblings of many, there are already signs of inflation, ex. oil prices up 25-30% in as many days, interest rates pushing higher on the 10 yr. note, gold prices popping, etc. As for whether I feel there will be rampant inflation, well I think it is inevitable if the Fed succeeds in what it is doing. If the Fed fails, that Japan-style deflation is the course du jour. The insolvent banks (which is damn near all of the big ones) will die with a sharp spike in rates. For one, even with the cooperation of FASB mark to make-believe GAAP accounting rule changes, the banks still have to discount expected future cash flows of the overpriced, overlevered, poorly underwritten derivative leveraged loan, consumer credit and mortgage trash on their books - and that discounting hurdle rate will be hard to fudge in an attractive direction as rates surge. Add to the problems in fantasy land, the fact that in the real world, higher rates will mean higher real defaults due to larger debt service, lower property values due to higher financing costs, and much more competition from the distressed markets - not to mention leveraged corporate defaults combined with the fact that their funding costs from demand deposits will shoot up - and you have a recipe for bank bangup 2.0.

A few readers of the site have commented on an explosion of bank reserves leading to the potential lending induced inflation are missing the primary reason for the Fed's gushing so much liquidity in the system in the first place. The major lending mechanism in this country, if not the world - securitization - is for all practical intents and purposes, dead! The Fed has plenty of leeway in supplying excess reserve capacity to banks and even having them lend it out because the banks a) will not and b) cannot lend off of their balance sheet at the same volume or velocity that they were willing to lend off of the global bond market's balance sheet. In more simpler terms, the era of OPM (other people's money) is over, at least for now. Those entities that lend money will now be doing it for real, versus packaging up flagrantly (under) underwritten IOUs to sell off to some fund somewhere across the globe. If I am not mistaken, banks can double their lending capacity and still not come close to equaling the pending capacity seen it the years surrounding the mid 2000's. This is a good thing, for it was too much debt. The question is will the defacto shrinking of credit stemming from the demise of the massive global credit card known as securitization, be enough to quell the inflationary fires being stoked by the Fed's "liquidity-at-any-cost" program? Remember, I brought this topic up exactly 6 months ago hn many poo pooed the idea... see Economic contractions AND rising prices, dare Reggie utter the "I" word - Enter a global phenomenon.

For those who have met me at the blog gatherings, you know that I am not a fan of gold as an investment or an inflation hedge. Yes, it has shown high correlations with inflation in the past, but it has also hiccuped during certain times as well. Even more importantly, now that we are no longer on a gold standard, the value gold has other than its industrial capacity is the speculation that you can get somebody to pay more for it at any given time, just because. Its intrinsic value is specious at best. Then again, that is my not so humble opinion. My preference is to have an asset that provides a strong hedge against inflation, but has the ability to generate cash flows or otherwise provide a utility of significant value if I am somehow (God forbid) wrong about my inflation correlation thesis. IMO, gold is not the universal answer. I know I stand in the exteme minority on this topcic, but those who have been following me for a while know that is where I like to be and were I perform best. In addition, gold is mentioned by every day trading board you come across. That can't be a good thing either.

An independent, empirical look at potential inflation hedges/speculative plays.

We have calculated the inflation correlation of several asset classes including commercial real estate (and its subsectors), global equities, emerging market equities, emerging market debt sovereign debt, precious and industrial metals and international treasuries....

Commodities:

Among non-agricultural commodities, Gold and Crude have a relatively high correlation with inflation @ 0.68 and 0.64, respectively. Other commodities including silver, copper and aluminum have positive but low correlation with inflation.

• Although over a longer time period there is consistent positive correlation, there is spurious link in the interim time period for both Gold and Oil particularly during 1990's when Gold and Oil prices were declining.

Real estate sector

• In the real estate sector both residential and commercial assets have one of the highest correlations with inflation @ 0.87 and 0.89, respectively. Within the commercial real estate sector, correlation with commercial apartments is the highest at 0.90 while that of Office / Industrial / Retail is slightly lower at around 0.87 suggesting that prices in apartments adjust faster than office and retail buildings,primarlily due to shorter lease -term contracts for apartments that allow for faster turnover of rents, hence the ability to match revenue and expenses more accurately in periods of rapid inflation. You see, your average economics teacher may tell you that the value of real assets go up in inflationary times, but that simple statement fails to capture full reality in the real world. In the real world, inflation drives up your holding, maintenance, construction and input costs just as it drives up nominal rents. the problem is that those rents need to be turned over into new leases in order to capture the increased rent potential (unless a sliding inflation scale or something similar is already embedded into the lease). Those that can't raise rent to match the increase in rental costs will actually lose money and in more extreme cases - lose the property.

The The real estate sector in general also has high correlation consistently across different time periods.

Equities

• Domestic equities (U.S) have a correlation of 0.88 with inflation. Correlation between inflation and Global equities (MSCI World) is at 0.92. However correlation with Emerging market equities seem to be lower with correlation of 0.75. The Chinese market in particular has a low correlation of 0.58 with U.S inflation. Both Russia and China had negative correlation with inflation in U.S during 1990's. However since 2000 onwards the correlation has turned positive.

Emerging market debt

• There seem to be no concrete relationship between emerging market debt and U.S inflation. India's Sovereign debt has low correlation of 0.25 while Brazil and Russia have negative correlation of 0.16 and 0.04, respectively.

Note: I will probably share some of my inflation speculations with paying subscribers over the next few weeks.

The table below shows correlation of inflation with different asset class for different time periods.

The table below shows correlation amongst asset category, primarily from diversification perspective.

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The table below shows correlation amongst asset category, primarily from diversification perspective.

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