In our June Issue of Art Fund Tracker, we enumerated the factors that led us to believe – as we still do – that an allocation to real assets like fine art in the form of a well diversified art fund could help protect against the damaging by-products of inflation and volatility.  Since then, a significant shift in investors’ anticipation of inflation has occurred.  At least for now, a growing number of investors view the probability of deflation, or at least some policy mistake that would create deflation, the greater risk. 

We have seen that concerns about global deflation have dominated the financial markets for the past few months and how much of a worry it is seems to depend on the economic report of the day. Indeed, sometimes the debate between global growth and retraction can happen within a span of a week.  What is unique and stoking the debate, is the bifurcation globally in terms of inflation/deflation. 

Rapid economic growth has driven up price and asset inflation in China, India, Brazil and other emerging economies. These are regions with relatively low incomes and high and rising rates of inflation.  Then there's the other side of the story, places like the US, Western Europe, Japan and Australia, which have slower economic growth, higher incomes and lower inflation rates. Deflation has been seen in other countries – Japan is the example most-often identified – but deflation on a global scale is rare.

In fact, before Japan’s on-again, off-again experience with deflation starting in the 1990s, one has to go all the way back to the Great Depression to find another sustained bout of this trend in the developed world.  While a brief bout with deflation may be a threat in the short run, most analysts believe inflation still remains the bigger long-term menace. 

So what does all this mean for art as an alternative investment?  For institutional investors, there are many factors at play which support the case for investing in art right now. One of the key issues going forward will be firstly diversification of the asset mix and secondly protection against inflation in order to match future liabilities. 

Most recently, the Russell Investments 2010 Global Survey on Alternative Investing published in June re-confirmed that alternative investing has survived the global financial crisis of 2008 and early 2009 and is poised for recovery and increased allocations in the coming years by institutional investors. 

Alternatives have gained a solid reputation as portfolio diversifiers and risk-mitigators, and they are expected to gain momentum even if the current global recovery were to falter.  The survey found institutional investors expecting (on average) an increase of over a third (from 14 per to 19 per cent) in their allocation to alternatives over the next two to three years.

Private equity and hedge funds remain the preferred alternative types, although real assets are expected to make meaningful gains, albeit from their current low allocations.  If our experience of the inflationary 1970s and 1980s is anything to go by, then investors should make sure they own some assets that are real rather than financial. And the better quality and more scarce they are, the better.  Art’s investment performance has been strongest during periods of currency devaluation or price inflation - which is the direction we look to be heading.

In June we also saw the publication of the World Wealth Report 2010 by Capgemini and Merrill Lynch in which they noted high net worth individuals were also returning to investments in art. With financial markets still in a flux, some high net worth individuals surveyed indicated that they also approached art as a good financial investment seeking out those items perceived to have tangible long-term value. In fact, among HNW “investor-collectors”, art is the most likely of all such investments to be acquired for its potential to gain value.  Art investors in countries such as India, China, and the Middle East also have a higher predilection to hold tangible assets like art as a possible inflation hedge.

The Merrill Lynch/Capgemini report also indicated that the demand for investments of passion overall is likely to increase in 2010 as wealth levels rebound, evidenced by the fact that auction houses, luxury good makers and high-end service providers all reported signs of renewed demand in the early part of 2010.  

According to Robin Duthy, head of Art Market Research, the art market has bounced dramatically off the lows reached in October/November 2009.  “The variation in performances is remarkable” says Robin, “and the Old Masters 100 Index is, amazingly, in new high ground standing 7 per cent above the high reached in the boom in 2008.”

Meanwhile, according to Robin, European Impressionists are still 54 per cent off their 2008 peak, the Modern Art 100 Index is 38 per cent off and Contemporary Art 100 is 49 per cent off.

Interestingly, the Contemporary Art 100 Index with Damien Hirst stripped out is just 35 per cent down from the 2008 peak - showing how far the exceptional £110 million Sotheby's sale of Hirst's work in September 2008 skewed that index.  But if apart from Old Masters the market is well below its recent highs, a 15-year view shows an overall growth of 350 per cent for Old Masters, 410 per cent for European Impressionists, 300 per cent for Modern Art and 410 per cent for Contemporary. Moreover, though all art market sectors, whether previously regarded as blue-chip or high risk, have shown they are vulnerable, the recent performance of Old Masters demonstrate a preference for the tried and tested, and a retreat to safer ground.

For further information on Art Market Research go to www.artmarketreport.com”.

(Randall Willette is a member of WealthBriefing's editorial advisory board).