An excellent article on Inflation. It relates inflation to investments and personal finances.
Which decade witnessed the largest stock market decline in U.S. history? The
decade starting with the Great Depression? The Panic of 1987? The most recent
decade with its two crashes? After adjusting for inflation, it turns out that the
1970s was the worst. While the Great Depression produced the largest nominal
percent point drop, it also generated a period of deflation. So there were fewer
dollars to spend, but each dollar retained bought you more bananas. Total real
purchasing power was "only" reduced by about 45%. In contrast, the OPEC
crisis during the 1970s, along with its double-digit inflation, reduced purchasing
power by almost 50%.
Indeed, one of the biggest threats to your portfolio's performance over time is
inflation. For every additional point of inflation, your portfolio will lose about 20% of its purchasing
power over the next 25 years. In addition, taxes are levied on your portfolio's nominal return, even if it
does not experience a real increase in purchasing power. All combined, you can easily lose a third or more
of the value of your portfolio over time with just a tiny bit of extra inflation.
Moreover, unlike jarring market crashes -- such as the Great Depression or the recent crisis -- inflation
lurks in the shadows. It destroys value by gradually eroding real returns over time. It is financial death by
a thousand cuts. Investors too often look at "the numbers" in their portfolio without asking what those
numbers can actually buy over time. It's a classic mistake that John Maynard Keynes termed "money
illusion."
But there are two good reasons to now start paying close attention to inflation again. First, the expansion
of the Federal Reserve's money supply during the past 18 months has been enormous and unprecedented.
As Milton Friedman most clearly articulated decades ago, more money chasing the same number of
goods usually generates higher prices. In fact, had the recent monetary explosion happened during
"normal" times, prices would have likely doubled. Second, projected federal deficits are ballooning out of
control. According to the Congressional Budget Office, the new Obama Budget will add almost $9.8
trillion to the national debt over the next decade. Astonishingly, the market has even recently priced some corporate bonds corporate bonds as safer than government securities. Eventually, it will be too tempting to reduce the
value of this snowballing debt simply by printing more money.
Inflation hawks have now begun circling. Some investment advisors are urging their clients to buy gold
and other commodities in order to maintain purchasing power as the value of the dollar shrinks. But these
hawks are no longer just located in the outer circles. At a recent FOMC meeting, the Kansas City Federal
Reserve's president broke ranks with the rest of the members by voting against the continued era of cheap
money. Even the Chinese government, who now holds almost 10% of U.S. debt, has expressed a desire
for a new currency to replace the U.S. dollar as the world's benchmark, although concerns about a massive
Chinese selloff of dollars are likely overblown.
To be sure, recent core inflation numbers (that exclude volatile food and energy) have been well below
expectations. Given the severity of the economic slump, many experts believe that low inflation will
continue for a while. In March, the presidents of the regional Federal Reserve banks in Chicago and St.
Louis called for continued "accommodative" monetary policy, which is just code language for more of the
same loose controls on the money supply. Opinion pieces in the Wall Street Journal and New York Times
have even argued that the deficit hawks should simply go away.
For investors, however, the current debate over the inflation outlook is incomplete and misleading.
Diversified investors hold many types of assets. Some of these investments are more sensitive to inflation
over the short run while some are more sensitive over the long run. Both time horizons should matter to
investors.
In the short run -- say over the next three years -- inflation is likely to continue to be quite low. One
reason is that explosive growth in the Federal Reserve's balance sheet has been mostly matched by
enormous increases in excess reserves held by commercial banks despite a very steep yield curve. In
other words, the banks are "hoarding the cash," preventing it from becoming part of everyday
transactions. Why? One reason that is the Federal Reserve now pays banks interest to encourage them to
hold additional reserves. Some banks also fear that rising short-term interest rates will increase their costs
over the life of the loan. (Their fears are indeed reflected in prices of one-year futures contracts for Fed
Funds.) More importantly, the banking sector is just in "Phase One" of the residential real estate mortgage
crisis, the so-called "subprime" mess. Phase Two -- defaults of "Alt A" types of residential loans that were
often issued to sole proprietors with less formal income documentation -- will begin later this year. Phase
Three -- defaults of "Option ARM" loans in which interest rates sharply increase a few years after the
loans start -- will begin to increase next year. Banks need to reserve against all of these potential losses.
Of course, if banks happen to be over-reserving for these losses, then inflation might come sooner if the
Fed can't quickly yank money out of the banking system. But that scenario is unlikely. Indeed, "Phase
Four" of the mortgage crisis -- this one stemming from the commercial lending side -- has received very
little attention this far. If anything, banks are probably still not reserving enough for these defaults.
Combined with the recent economic slowdown in Europe, it is likely that inflation will be held in check
for a while.
But longer-run inflation (beyond five years) should be on everyone's radar screen. In fact, it is unlikely
that the current yields on 30-year Treasury securities will be enough to cover inflation over time, much
less provide a real return. Present value shortfalls in Social Security and Medicare are in excess of $70
trillion and will likely lead to an "inflation tax." Yields on 10-year Treasury securities -- which
policymakers try to keep low because of their indirect relationship to mortgages -- may not be high
enough to cover inflation.
So what is an investor to do about inflation? The traditional choice is to invest in commodities, metals, oil
and the like. The broadest investible measure of commodities is almost 85% correlated with the
Consumer Price Index (CPI) on an annual basis, meaning that the value of commodities tends to move in
the same direction as inflation. Gold is almost 60% correlated, oil stands at 21%, and real estate and
natural gas are both at 5%.
But, contrary to conventional wisdom, none of these asset classes are actually good inflation hedges
anymore. They are already too popular.
Indeed, don't be fooled by correlation. Two data series can appear to be highly correlated even though one
of them consistently underperforms the other. In fact, commodities are about the only major asset class
that actually underperforms the CPI over time. More targeted sector plays -- such as gold, oil and natural
gas -- tend to beat the CPI, but not by nearly enough to compensate for their enormous risks (they are
about twice as risky as the S&P 500). In fact, corporate bonds and equities actually appear to do a better
job of "keeping up" with the CPI over time on a risk-adjusted basis, despite their low mathematical
correlation.
A few specific investment recommendations, starting with the lowest hanging fruit:
Increase your exposure to Treasury Inflation Protected Securities (TIPS) inside of your tax
advantaged retirement accounts. Put a quarter or more of your retirement stash into TIPS.
While TIPS are not tax efficient enough for taxable accounts, they provide a good inflation
hedge for retirement accounts where taxes are either deferred or already paid.
1.
For your taxable accounts, buy $10,000 per year in Treasury I Bonds. Like TIPS, I Bonds
provide solid protection against inflation. Unlike TIPS, you are not taxed on "phantom
income" along the way. Because I Bonds are such a "win-win", the government caps the
amount that you can purchase each year to $5,000 in paper form and $5,000 in electronic
form. So do both.
2.
Invest up to 15% of your portfolio in emerging market equities. To be sure, many of these
markets have already experienced large gains recently. But they still offer a "twofer" of
sorts: a hedge against U.S. currency depreciation as well as diversification into countries
that still have strong growth prospects.
3.
Move some of your lower yield government bond portfolio toward Ginnie Mae centric
mutual funds. Ginnie Mae's are the only mortgage-backed securities carrying the full faith
and credit of the federal government. They usually provide a yield between one half a
percent and one percent greater than comparable maturities.
Wednesday, March 31, 2010
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