Amidst the gloom and doom regarding the resurgence of inflation, one of the points that’s been lost is the fact that inflation is effectively a transfer of wealth from creditors to debtors, making bond (and cash) holders the worst affected. Generally, when this inequality is created (which is what drives the engine of capitalism), indebted firms and individuals have the ability to reduce the real value of their liabilities, and generate wealth.
This is predicated on the fact that the asset side of the balance-sheet is healthy enough to withstand the rise of interest rates as well as the bet that asset price rises outpace inflation. Even as high rates of inflation fundamentally destabilize large parts of the economy and impact consumer spending as it stunts the standard of living, a look at historical data reveals that capital formation took place and formed the basis of asset price appreciation.
Once the intoxicating mindset of rising asset prices took hold, values reached silly levels as it became common sense to borrow money to deploy them into rising prices. In other words, the very belief in the permanence of economic growth undid economic growth. This implies that expectations take hold regarding asset price inflation as well as for consumer prices.
A two-way investment flow
The Dow Jones index was no higher in 1982 than it was in 1965. The subsequent disinflation led to a 40-year bull run, which has only punctured this year. If inflation and/or deflation overwhelms the government’s commitment to manage the business cycle, the implicit social contract between the government and its people breaks down.
In the UAE, we have seen an accelerating pace of reforms, which has led to a watershed in changed corporate and individual behavior. First unleashed through the freehold phenomena, the breathtaking pace of changing the structure of the economy has meant capital and talent has gushed in.
Therefore, we are seeing two kinds of transfers in wealth: 1) the transfer due to inflationary forces and 2) a geographical shift both in terms of expat investors coming into the UAE, as well as domestic companies indulging in foreign acquisitions (eg, Aramex, IHC, Burjeel, Amanat etc). The current global economic turbulence has bred a new form of anxiety for the median investor of whether and where to invest.
In the ever expanding array of choice that is now presented - from startups, to capital markets, to real estate) - the enduring dilemma remains: how much do we tolerate present discomfort for future gain? The dilemma is even more problematic given the first order effects of rising inflation are pleasurable. People suffer from ‘money illusion’, as they believe that higher salaries and profits reflect real rather than nominal gains. Assets that sustain the inflationary onslaught are therefore not the ones that only pay coupons, but those that have an enduring advantage by virtue that it becomes more expensive to ‘replace them’ (propelled higher by cost push inflationary forces).
Stick with equity, real estate
If all of this sounds complex, individual investors would do well to remember the following: a) Inflation erodes savings and therefore the impulse to increase allocations in equity assets and real estate should be higher (as opposed to fixed income and cash), and b) Western asset values have gone through cycles whereby price rises have been extraordinary relative to history even after their correction this year. The same does not apply to the UAE.
Public fascination with where the Western markets are heading every day spawn more than its share of prognosticators. Public faith in the stability of Western financial markets are being forced to evaluate what they consider to be stable and predictable. It is in this process that asset markets in the UAE are now being moved front and center of a macro-asset allocation shift. This shift is being accentuated by the inflationary forces that are in play.