Specter of Inflation
Only six months ago, inflation was the last thing on anyone’s mind. Deflation threatened as prices — especially energy prices — plunged to record lows. Following massive Fed and government intervention, focus has shifted. While deflation is still a possibility, it is now unlikely given the enormous amounts of money being injected into the economy.
With massive sums of money being injected into the economy — a table in a recent Fed report indicated that the potential support to the economy could reach 21 trillion dollars — inflation is the more likely scenario. Only a small fraction of the money being used to support the economy is coming from the existing money supply. Most of the money being injected into the economy — through TARP, the Commercial Paper program, treasury buying, etc — comes from newly minted money. The Fed is doing what the Fed does best; it prints dollars.
I agree with most of what the Fed is doing. The economy needed massive stimulus to avert a complete meltdown, and continues to need a lot of stimulus. The problem is with balance. Forecasting the economy — or even measuring its current state — is a job best done by palm readers and astrologers. Even a slight over stimulation of the economy — say $200 billion — can cause substantial inflation. With the Fed throwing around trillions of dollars, getting the right balance of stimulus becomes nearly impossible. Higher-than-normal inflation is almost a certainty.
A little bit of inflation is a good thing. In the United States, we seem to like it where it does not approach threatening proportions in the 2-4% range. In reality, inflation rates anywhere between 2-8% are considered healthy. Many countries comfortably handle 8% inflation rates without any negative economic impact. Nevertheless, with the amount of stimulus in the economy, the possibility of inflation higher than 8% is significant, and whereas hyperinflation was previously an impossibility, it is now possible, albeit unlikely.
Forget about Gold
Whenever inflation comes up, so does gold. I honestly cannot explain to you what gold has to do with inflation, since the world is no longer using gold as a currency standard. Gold does make some sense on the level that it is a commodity, and all commodities tend to rise in price with inflation since they tend to be priced in dollars. I personally suggest avoiding gold. Gold is the first refuge of panicky idiots, and as such suffers from wild speculatory swings. Instead, consider buying into a no-load commodity mutual fund — diversifying among commodities, including agricultural products, metals, oil and natural gas, will protect you from speculators and inflation alike. From a value perspective, I’m not convinced that now is the best time to buy into commodities, but buying into any significant dips may be beneficial in the long-term.
Stocks
Stocks have natural inflation protection. So long as the inflation is not at the panic-inducing level, stocks will benefit. Stock prices tend to rise with inflation because of both the inflationary effects buying the actual shares and the higher nominal revenues/earnings associated with inflation.
To double-up the effect, buying stocks that are strongly connected to a commodity is a way to avoid dealing with the commodities market. I recently recommended natural gas company, EnCana.
Bonds
Bonds and cash are typically thought of as the enemy to an investor in inflationary times. This is not necessarily true. Treasuries can be a drag on a portfolio when inflation is high, but not all bonds are treasuries. Investors preparing for an inflationary environment may consider weighting their bond portfolio more heavily towards higher-yield bonds, such as investment-grade corporate bonds or a high yield bond mutual fund. While returns may or may not outpace inflation, they will certainly be less of a drag than treasuries. Nevertheless:
keep in mind that an inflationary environment can be an excellent time to buy good bonds at cut-rate prices.
The exception is with TIPS. TIPS, or Treasury Inflation-Protected Securities, are a new type of treasuries that track inflation. One can buy them directly, or through a TIPs mutual fund.
Most Importantly, Go Global
I cannot understate the importance of having a global portfolio. The world of investment opportunities does not exist within the boundaries of the United States. By diversifying assets globally, one mitigates issues that affect only the United States, especially inflation. By investing in stocks, bonds, and even CD’s internationally, one can reduce inflation and currency risk in the aggregate.
That Being Said…Don’t Overdo It
A good portfolio shouldn’t need tremendous tweaking. Good stocks and good bonds will generally be good stocks and bonds over the long term. Severe inflation is not likely to last longer than a few years before the fed can launch an effective counter-attack, so there is not much sense in shifting one’s entire portfolio to fight its ugly face. Focus on value and don’t get sidetracked by speed bumps like inflation.
What is a good asset mix?