Keeping it Real (as in “Real” Returns) The following was excerpted from Third Eye Capital Management Inc.'s Q1 2011 Investor Letter.

Inflation is one of the biggest threats to an investor’s portfolio over time. It is also one of the most challenging risks to hedge because at best, any such hedge is imperfect and at worst, it fails to work. This challenge coupled with benign inflation statistics published over the last decade by governments in Canada and the U.S., means investors have likely become complacent about inflation. But the outlook for inflation is changing, and investors need to reconsider their asset allocations in order to maintain the purchasing power of the capital and returns of their portfolios.

There is a wide divergence of expert opinion on the outlook for inflation, even among policymakers. In Canada, the Bank of Canada expects prices and wage growth to be restrained by the strong loonie and sees both consumer and core inflation figures easing in the second half of this year. In the United States, the Kansas City Federal Reserve president voted against fellow members of the central bank by calling for tighter monetary policy to curtail future price inflation. For some economists, unprecedented money supply, mounting government deficits, and rising commodity prices are sure signals of a serious inflation problem on the horizon. Others believe there is ample slack in the economy evidenced by drops in industrial production and spikes in unemployment. Recent data from the OECD shows that developed economies are experiencing the lowest negative output gap since World War II. While the output gap is difficult to quantify, other measures of excess capacity such as capacity utilization and unemployment highlight continuing slack.

For investors, the inflation debate is more about timing. Most of the endowments, foundations, and pension plans we speak to do not perceive the threat as immediate but believe price pressures are forming in certain economies and that the secondary inflation effects of rising commodity prices has the potential to surprise on the upside. Asset-allocation decisions are increasingly taking inflation expectations into consideration, and investors are probing for insights on how to maintain the purchasing power of their assets over time and achieve real returns consistent with their investment objectives.

Conventional wisdom says that equities, real estate, and commodities are the most effective hedges against inflation. Bonds, and other debt instruments, according to the traditional view, are the worst because, in a rising inflation environment, fixed coupons and principal repayments are received with funds that have less purchasing power. But theory does not always match reality.

Equities represent a claim on dividend streams of corporate assets that are supposed to be able to pass on inflation in the form of higher prices. Inflation, however, can cause volatile earnings depending on the price elasticity of demand for a company’s products, and increase the risk-premium required by investors. Under these circumstances, equities may have a negative correlation to rising inflation. Take the experience of the 1970s, when inflation rose but most equity markets suffered negative real returns.

Real estate can be valued in a similar manner to equities and bonds, by discounting the expected future stream of cash flows by a required rate of return. These cash flows, in the form of rents and sale values, tend to move in line with inflation. However, a research paper published in the Journal of Real Estate Finance by Joseph Gyourko and Peter Linneman, entitled “Owner-Occupied Homes, Income Producing Real Estate, and REIT as Inflation Hedges”, concluded that real estate in its securitized form (i.e, REIT) exhibits the same negative relationship found with equities. The effectiveness of purchasing private real estate as an inflation hedge is also dubious if excessive leverage is used and if the timing of purchase is wrong.

There has been a lot of analysis about the inflation-hedging properties of commodities, and research does provide strong evidence that, at least in the short-term, commodities do provide effective inflation protection. In April 2009, the IMF sponsored a study that found, over the long-term, the effects of inflation caused commodity prices to fall gradually over time. The reasons were best described by Professor Jeffrey Frankel at Harvard University, who argued that higher real interest rates in response to an inflation shock caused commodity prices to fall due to three main factors: by increasing the discount rate for future extraction and growth in current supply; by raising the carry cost of inventories; and by encouraging speculators to shift out of commodity contracts and into treasury bills.

All the empirical evidence seems to support the theoretical arguments that bonds are a poor inflation hedge. However, bonds are a heterogeneous asset class and certain offerings like private credit can be very effective at outperforming inflation. Private credit instruments are typically short-term, so are less susceptible to duration risk, and have floating rate structures that reduce reinvestment risks that can erode purchasing power. Equally important, private credit instruments are over-secured, usually by a factor of 2 to 1, by business assets with visible values, which means that debt outstanding in notional terms is actually secured by assets valued in real terms. In an inflationary environment, private credit intrinsically becomes less risky and more valuable at the same time. What other investment can make that claim?

Milton Friedman, the Nobel Prize winning economist, stated “inflation is always and everywhere a monetary phenomenon.” Given the massive liquidity injections and ultra loose monetary policies employed over the past few years, inflation hedging should be an important component of any investor’s investment policy. It is difficult for a long-term strategic asset allocation to protect a portfolio against unexpected inflation, especially using traditional asset classes. However, there is an opportunity to enhance inflation protection in any portfolio through the tactical use of private credit.

Third Eye Capital Management Inc.