Portfolio, Action & Research Team

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1 Portfolio, Action & esearch Team Michael H. Herring, CFA, CMT, Investment Strategist January, Where to Find Inflation Protection Since the onset of the financial crisis in 7, central banks around the world have acted aggressively to provide liquidity to global markets to stave off the potential for a deflationary debt spiral. In addition, governments have implemented fiscal stimulus that is resulting in burgeoning deficits. As we all know, there are only three ways governments can reduce deficits and debt: raise taxes, lower spending, or print money to reduce the real value of the debt. Of these three, the risk to the public and investors is that the third option is generally the most palatable to politicians, inflation in effect acting as a stealth tax on incomes and wealth. This has naturally led to many of our clients expressing increasing concern about the potential for higher consumer price inflation in coming years. The questions we are constantly being asked are What are the best investments during a period of rising inflation? and, How should a portfolio be positioned if we are about to experience a surge in the inflation rate? Inflation Is a Fact of Life Chart 1: Canadian Consumer Price Index (CPI) Year-Over-Year % Change Jan-1 Jan- Jan-3 Jan- Jan- Jan- Jan-7 Jan-8 Jan-9 Jan- Source: Bloomberg Canadian Consumer Price Index (CPI) Year-Over-Year % Change Median Canadian CPI Chart : U.S. Consumer Price Index Year-Over-Year % Change, (NSA) 3 1 Before we provide our answers to those questions, a brief review of the history of inflation is in order. Inflation has been a fact of life for North Americans for most of the last century. - - U.S. Consumer Price Index Year-Over-Year % Change Median CPI (NSA) -1 In Charts 1 &, we show plots of the year-over-year - change in the Consumer Price Indices (CPI) for Jan-13 Jan-3 Jan-33 Jan-3 Jan-3 Jan-3 Jan-73 Jan-83 Jan-93 Jan-3 Canada and the United States from the early th Source: FB St. Louis century through to the present day. We can see wild swings in the CPI in the early decades in the chart, with two prominent periods of CPI deflation in both countries at roughly the same time.

2 Where to Find Inflation Protection, January, In addition, we can see that inflation accelerated into double-digit territory in the 197s in both countries, and then the onset in the early 198s of a protracted period characterized by disinflation, or falling rates of inflation, that has persisted to the present day. Chart 3: What C$1 Buys Today $1. $1. $.9 $.8 $.7 Inflation Is Pernicious What is not evident in the charts of the yearover-year change in CPIs is the pernicious cumulative effect of inflation on purchasing power. In Charts 3 &, we show the path of the ongoing degradation of purchasing power on a CPI basis in Canada and the U.S. We can see that in both countries the purchasing power of the currency has fallen roughly 9 percent in the last 9 years. In other words, it takes a dollar today to buy what a nickel bought in the early th century. Even Low Inflation Is Potent Even relatively low rates of inflation can diminish purchasing power meaningfully over long timeframes. Looking again at Charts 1 & on the previous page, we can clearly see that inflation as measured by CPI has moderated considerably since the early 199s, settling into a range mostly between one and three percent at an annual rate. And yet, in the low inflation decade ended December 9, purchasing power in Canada fell 18. percent, and in the U.S. purchasing power fell.1 percent. To us, this suggests that even if the worst fears of the inflation-phobes are not realized, investors still have a tough row to hoe in the years ahead. $. $. $. $.3 $. $. $ Source: Bloomberg, Chart : What US$1 Buys Today $1. $1. $.9 $.8 $.7 $. $. $. $.3 $. $. $ Source: FB St. Louis, With that in mind, let s turn our attention to asset classes. What Should Asset Allocation Look Like? In a general sense, if we believe that increasing inflation is in the future, we want to de-emphasize investments with fixed payments and emphasize investments that are closer to the real economy, and whose returns are positively correlated to inflation trends. We re going to look at government bonds, eal eturn Bonds (Bs) and common stocks in the following pages.

3 Where to Find Inflation Protection, January, 3 Long-Term Government Bonds Disappointing in Inflationary Times Based on the above, nominal (i.e. not adjusted for inflation) long-term government securities are not desirable in a portfolio if inflation is in a rising trend. After all, long-term government bonds have fixed payments and you re locked in for the life of the bond. In Chart, of eal eturns on North American (nominal) Government Bonds, we can see that long-term bonds exhibit multi-decade periods of high single-digit real (net of inflation) compound rates of return alternating with multi-decade periods of low or negative rates of real compound annual return. Chart : eal eturns on North American Government Bonds, eal eturn on Long-Term Canada Bonds eal eturn on Long-Term US Treasury Bonds Source: Dimson et al, Triumph of the Optimists,, Portfolio Services Group, Bloomberg The two alternating periods are characterized by falling inflation and falling long-term yields (positive real returns), and rising inflation and rising long-term yields (flat-to-negative real returns), respectively. We can see the legacy of the U.S. Federal eserve s ( the Fed ) last attempt to engineer lower Treasury yields: an epic, four-decade bear market for long-term government bonds, during which the yield rose from approximately. percent to more than 1 percent. Over that time, investors consistently experienced a negative rate of real return and that is before taxes are taken into account! No wonder government bonds earned the sobriquet certificates of confiscation during that time. With inflation and long-term bond yields at low levels, and the Fed again trying to engineer a lower level for government bond yields through purchases of Treasury, agency and mortgage-backed securities, it appears to us that there is heightened risk that we will soon embark on another era characterized by rising rates of inflation and therefore long-term bond yields. If that is the case, longterm nominal bonds should be underweighted, or eliminated entirely from portfolio asset allocations. Shorter Bond Portfolios Preferred In an environment of interest rates generally moving sideways or gradually rising over time, we would expect laddered bond portfolios to exhibit good risk-adjusted rates of return vis-à-vis the broader bond market. We suggest a -year laddered portfolio of government bonds as the best option. This portfolio will be more responsive to changes in short-term rates, which are far more volatile that longer-term rates. This means a short-term ladder would be more responsive to changes in the inflation rate. With this shorter-term ladder, you will have more opportunities for reinvestment than with a longerterm bond ladder, and much less price sensitivity to rising yields. What About eal eturn Bonds? In recent months we have been inundated with questions from clients about eal eturn Bonds. In fact, it is those questions that spurred us to write this essay. Specifically, clients are asking whether the time is right to be buying Bs. eal eturn Bonds were first introduced in Canada in 1991 and are traded and quoted on a real (or net of inflation) yield basis. This is different than the yield as quoted on nominal bonds. The yield on nominal bonds can be thought of as being the sum of three components:

4 Where to Find Inflation Protection, January, 1) the real yield ) compensation for the expected rate of inflation over the life of the bond 3) compensation for the risk of a surprise increase in inflation over the life of the bond The real yield on an B is stripped of the latter two components shown above. Instead, the investor receives compensation for changes in the CPI over the life of the bond. So, before taking into account taxation and the relevance of the CPI to the investor s own experience of inflation, the investor is made whole on any increase in the CPI. However, and this is important to note, if the Canadian economy were to experience deflation, the investor in an B would see a reduction in principal and interest on the invested amount during that period of time. For our purposes though, we are assuming that CPI inflation will rise and we will evaluate Bs on this basis. Chart : Government of Canada Bonds + Years to Maturity Jan- Jan-3 Jan- Jan- Jan- Jan-7 Jan-8 Jan-9 Jan- Source: Bank of Canada Chart 7: Long-Term eal eturn Bond Yield In Charts & 7, we can see the yield on Government of Canada (nominal) bonds of greater than years term to maturity since 19, and the real yield on long-term Bs since the inception of the market for Bs in We can see that long-term nominal yields have just begun to rise off of -plus year lows, while at the same time B yields have been falling and are approaching their all-time low yield of 1. percent set in July Source: Bloomberg, eal eturn Bond Yields are approaching their long-term lows again This divergence between the yield on long-term nominal bonds and long-term Bs means that the breakeven rate of inflation has risen markedly. In other words, the level of long-term inflation at which an investor would be indifferent between a nominal and a real return bond has risen. This, in effect is a measure of how willing investors are to pay up for inflation protection (Chart 8 on the following page). As we wrote above, the prior secular bear market (19 198) for long-term bonds was characterized by rising nominal and real yields. In fact, it was the very high real yields available on long-term government bonds at the onset of the disinflation of the 198s that made possible the very high net-of-inflation returns for long-term bonds from 198 through to the present day. Nominal yields and, by inference, real yields have shown a tendency to respond to changes in the inflation rate with a lag. If we are trying to protect investment portfolios from prospective increases in the inflation rate, by extension we are expecting an eventual rise in nominal and real yields over time.

5 Where to Find Inflation Protection, January, Like long-term nominal bonds, long-term Bs exhibit very high price sensitivity to changes in yields. Therefore, Bs, most particularly long-term Bs, are not particularly desirable in portfolios because, like nominal bonds, they would be expected to incur losses on a price basis in the event of rising real yields. And, the rise in the breakeven rate of inflation noted above is another mark against Bs, making them less compelling than they would be if the breakeven rate were lower. Now, Bs would be expected to outperform their nominal counterparts in the event of rising inflation and interest rates, but there is significant potential for low, or negative, rates of total return, if the economy were to embark on a multi-decade period characterized by rising inflation. Periods of high inflation tend to be characterized by high credit demand, which drives both nominal and real yields higher. From our point of view then, because of the very low level of their real yields, and the relatively high breakeven rate of inflation, Bs do not at this present time exhibit the characteristics we would seek in an inflation hedge. Equities Are Proven As Inflation Hedge Chart 8: Breakeven ate of Inflation for Long-Term eal eturn Bonds, % 3 1 /11/91 /11/9 /11/97 /11/ /11/3 /11/ /11/9 Source: Bloomberg, Chart 9: eal eturns on North American Stocks, 19-9, 1 The last asset class we will discuss in this essay is common stocks. In Chart 9, we show the compound annual real returns on North American common stocks from 19 9 in - year increments. In stark contrast to our earlier chart showing the real compound annual returns from long-term nominal government bonds for - eal eturn on Canadian Equities eal eturn on US Equities Source: Dimson et al, Triumph of the Optimists,, Portfolio Services Group, Bloomberg the same time period, we can see that equities were generally more likely to generate positive rates of real return. This tendency extends through the -year period when the compound annual rates of real return on long-term nominal government bonds were negative. During that time, the compound annual rate of total return from Canadian equities was.8 percent, and was.99 percent for U.S. equities. We would also emphasize that the returns shown in Chart 9 are for the broad market, so by definition some sectors of the market will have performed much better and some much worse over the -year timeframe. Also note that in none of the -year periods did Canadian equities experience a loss in real terms on a compound annual basis, while the U.S. equity markets show three -year periods where the -year net-of-inflation return was negative. We believe this is because of the heavy weighting of cyclical stocks in the Canadian market, as opposed to the higher diversity across market sectors in the U.S.

6 Where to Find Inflation Protection, January, In an upcoming publication, Technical Analyst uss Visch will delve deeper into the performance of equity market sectors during the surge of inflation from the late 19s to the end of the 197s. Summary Wrapping up the discussion, we rank the asset classes discussed above in the following order, based on their ability to protect investment portfolios from rising inflation: 1) Common equity, most particularly cyclical stocks, but also industrials ) Short government bond ladders 3) eal eturn Bonds ) Long-term nominal bonds. The conclusion that we draw from this discussion is that common stocks likely represent our best bet to beat any incipient increase in the inflation rate. For the bond component of portfolios, we would recommend shorter-term ladders of government bonds over long-term nominal or eal eturn Bonds. T13_MH (1//) General Disclosure: The information and opinions in this report were prepared by Inc., and Ltee/Ltd s Portfolio, Action and esearch Team ( ). The opinions, estimates and projections contained in this report are those of as of the date of this report and are subject to change without notice. endeavors to ensure that the contents herein have been compiled or derived from sources that we believe are reliable and contain information and opinions that are accurate and complete. However, makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions which may be contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this report or its contents. Information may be available to Nesbitt Burns or its affiliates that is not reflected in this report. This report is not to be construed as an offer to sell or solicitation of an offer to buy or sell any security., or their affiliates will buy from or sell to customers the securities of issuers mentioned in this report on a principal basis., their affiliates, officers, directors or employees may have a long or short position in the securities discussed herein, related securities or in options, futures or other derivative instruments based thereon., or their affiliates may act as financial advisor and/or underwriter for the issuers mentioned herein and may receive remuneration for same. Bank of Montreal or its affiliates ( Financial Group ) has lending arrangements with, or provides other remunerated services to, many issuers covered by Portfolio, Action and esearch Team. A significant lending relationship may exist between Financial Group and certain of the issuers mentioned herein. Dissemination of eports: Portfolio, Action and esearch Team s reports are made widely available at the same time to all Investment Advisors. Please contact your Investment Advisor for more information. Additional Matters TO U.S. ESIDENTS: Capital Markets Corp. and/or Securities Ltd., affiliates of, accept responsibility for the contents herein subject to the terms as set out above. Any U.S. person wishing to effect transactions in any security discussed herein should do so through Capital Markets Corp. and/or Nesbitt Burns Securities Ltd. TO U.K. ESIDENTS: The contents hereof are intended solely for the use of, and may only be issued or passed onto, persons described in part VI of the Financial Services and Markets Act (Financial Promotion) Order 1. and the roundel symbol are registered trade-marks of Bank of Montreal, used under license. is a registered trademark of Corporation Limited, under license. Member CIPF. NBI is a wholly owned subsidiary of Corporation Limited which is an indirect subsidiary of Bank of Montreal