Inflation will kill purchasing power: Graham

There’s no question about it — inflation is back, according to Gavin Graham, chief investment officer at Guardian Group of Funds.

Speaking to a packed house at the Financial Forum Expo this past weekend, Graham’s pronouncement was not earth-shattering — former Bank of Canada governor David Dodge tackled the potential of inflation and the risks of deflation last year when the sub-prime crisis began to ripple its way through the markets.

Yet, Graham believes that the obvious must be stated because boomers will invest with little thought or concern for the eroding market.

“There is an entire generation that really doesn’t factor inflation into their [investment] calculations,” said Graham. “We have forgotten about it because for the last 25 years, it has not been a factor.” Boomers typically hold a larger percentage of “safe” income investments that can quickly erode in a high-inflation environment. As such, Graham is prompted to assure investors that there are safer ways to ride out the volatile market and reduce the effects of inflation. In a nutshell, Graham suggests diversity and dividends.

For those still too reluctant to move away from bonds, Graham says some innovative products (such as inflation-protected bonds) will provide some refuge. However, he warns that the tax treatment on these vehicles is unfavourable unless they are held in an RRSP.

“Diversity means less volatility,” Graham said simply. “What it means is that you don’t go and buy conventional government bonds with a 4% yield with inflation at 4%.” If investors continue to invest this way, their purchasing power will diminish rapidly. To illustrate, he points out that U.S. Federal Reserve policies since the 1920s have reduced the value of $1 to $0.05 today. On an even shorter time horizon, $1,000 in 1980 would be worth only $380 a decade later.

Graham believes this next inflationary era, and the historical knowledge of past inflationary eras, will prompt investors to seek out inflation-resistant investments. It also means “borrowing from the first page of the Hitchhiker’s Guide to the Galaxy: don’t panic,” said Graham.

In practical terms, it means buying equities that can withstand the current market volatility.

Graham reaffirms the necessity of diversification by explaining the drop in America’s contribution to the world’s gross domestic product (GDP). Last year, the U.S. produced only 12% of the world’s GDP, compared to China, at 30%, and the other emerging economies such as India, Vietnam and Singapore, which had a combined contribution of 17%. “That means half of the world’s GDP came from emerging countries.”

By diversifying, investors can take advantage of sectors in which the U.S. is strong — such as pharmaceuticals and technology — while ensuring their portfolio is balanced with investments in other geographic areas and market sectors.

He suggests that investors need to remember that “just because the U.S. slows down does not mean you will stop buying fridges or flat-screen TVs or food or fuel.”

“Buy good profitable blue-chip companies with dividends that grow over time,” he says. “That would be a great investment strategy, and you would end up outperforming virtually everything else. You’d even get a pretty decent income out of it because these companies grow their dividends in line with their profits, and you get the dividend-tax credit.”

Originally published on Advisor.ca on January 28, 2008