Active debate continues on the future path of the US economy. One side, with the Federal Reserve strongly in their corner fears zero or lower inflation, aka deflation. The reason to fear deflation is that it can turn into a death spiral that is difficult to recover from. Ben Bernanke’s famous “helicopter” speech back in 2002 was entitled “Deflation: Making Sure “It” Doesn’t Happen Here.” (1) The speech was a precursor to many of the actions that the Fed has taken since the credit crash.On the opposite side are investors that think the US is headed for “higher” inflation. The range of higher inflation varies greatly. For example Ken Rogoff, co-author of “This Time is Different” has called for the Fed to work towards a target of ~ 4-6% inflation.(2) Other investors including some METARites fear even higher inflation, bordering on hyperinflation.This post will not add anything to the deflation versus inflation debate. If you are solidly in the deflation ad infinitem camp, you might as well skip this point. This post is intended for those in the higher inflation camp. Last year, TMF Morgan Housel had a post entitled: “The Other Side of Inflation” (3) which argued:Inflation, of course, raises prices, which is bad -- and that's usually where the criticism ends.But there's another side of inflation: the impact it has on wages and assets. If prices go up 10%, but wages and net worth also rise 10% (or more), are you worse off?”I posted in reply: “Why you should FEAR inflation.” (4) My main point was that equities and fixed income would suffer poor returns if inflation increased. Since then, Rob Arnott of Research Affiliates has chimed in with his concerns that equities and fixed income will suffer in an increased inflation environment.(5) In my post last year, I did NOT address how to invest if you expected increased inflation. This week John West from Research Affiliates published: “The Newlywed’s Dilemma” that specifically addressed how to invest for increased inflation. Rob and Research Affiliates are very adamant that traditional portfolios with traditional equities and fixed income are NOT well equipped if and when inflation picks up. They advocate adding a “Third Pillar” that will perform better with higher inflation. The asset classes they specifically recommend are:TIPSCommoditiesREITSEmerging market debtHigh yield aka junk bondsBank loansThe paper talks about having a 20% to 50% allocation to these new asset classes. I have previously heard Rob recommend having a 33% allocation. The paper presents back test results showing how each of these asset classes has performed including volatility. The paper has a lot of different facts, so I am not going to try and include them here. It discuses “low volatility portfolios”, “Optimized Strategies” versus “Heuristic Strategies” and several other obscure points. If you are interested, I recommend you read the paper.The paper does NOT mention this, but I do know that Rob manages the Pimco All Asset Fund aka PAAIX. It is specifically geared to be the “Third Pillar” that performs well under high inflation. If you do not want to roll your own inflation fighting portfolio, you might consider making a single investment decision by adding an allocation to this fund. There might be other funds that have similar goals, but I have not researched them.BOTTOM LINE is that IF you think the US is headed for increasing and/or high inflation, a traditional portfolio of stocks and bonds will not perform well. You need additional asset classes in significant proportions. Thanks,Yodaorange(1) Ben Bernanke speech: “Deflation: Making Sure “It” Doesn’t Happen Here.”http://www.federalreserve.gov/boarddocs/speeches/2002/200211...(2) Ken Rogoff: “The Second Great Contraction”http://www.project-syndicate.org/commentary/the-second-great...(3) TMF Morgan Housel: “The Other Side of Inflation”http://www.fool.com/investing/general/2011/07/22/the-other-s...(4) Yodaorange: “Why you should FEAR inflation”http://boards.fool.com/ot-why-you-should-fear-inflation-2943...(5) Jason Hsu: “The 3-D Hurricane and the New Normal”http://www.rallc.com/ideas/pdf/201106_3D_Hurricane_and_New_N...(6) John West, “The_Newlyweds_Dilemma”http://www.rallc.com/ideas/pdf/fundamentals/Fundamentals_Apr...
Yoda, I guess, despite the four stars, I'll need to lock myself in my cellar....or attic and study this one.http://portfolios.morningstar.com/fund/summary?t=PAAIX&r...In a way it seems to be like me. i.e. short cash! But there's the rest of it. Quite a lot to think about.jz
I scanned the "Newlywed" PDF to get a better understanding of why REITs were listed as a desirable component in a re-factored portfolio aimed at minimizing exposure to a "double whammy" of a dead economy and rising inflation. After reading the piece, I'm still doubtful of the logic.REITs manage portfolios of income-producing properties. I typically think of them as owners of skyscrapers and office buildings leased out to companies who don't want the headaches of managing buildings and grounds and don't want the drag of a large fixed capital asset on their books. REITs make money from managing the properties and charging a premium to tenants and in a market of rising real estate prices, by occassionally selling properties bought in cheaper times at a profit.The commercial real estate market grows in response to a combination of factors:* growing employment triggering employers to add more space* low interest rates and a willingness to lend* growing corporate profits allowing higher lease payments to be afforded by tenants producing higher monthly incomeI can see inflation rising if the Fed continues to create money and the velocity of money speeds up a bit. However, even if economic activity picks up a bit for that to happen, I don't see* wages going up -- too much competition within manufacturing and hi-tech "think" jobs* any relaxation of credit standards that would increase borrowing to bid up real estate asset prices* any material jump in corporate profitability to afford higher lease/rent chargesIf anything, higher interest rates will simply burn more dollars in consumer wallets, leaving LESS to spend leading to LOWER corporate profits, less ability to afford higher lease/rent charges and possibly HIGHER unemployment, reducing demand for space.Stated a different way, if we do experience a period of substantial inflation (something above maybe 7-9 percent), it won't be our Father's Inflation -- the kind produced by a combination of monetary policy AND an overheating real economy setting up a reinforcing spiral of higher wages and higher prices. This time, if we encounter high inflation, it will be purely monetary in origin, destroying purchasing power without stimulating the demand side of the equation by at least inflating wages in a token effort to keep up. There's simply no moat around the labor market to fend off competition from millions of workers in other economies to allow US dollar denominated workers to demand higher wages to keep up.WTH
Bank loans ???Inflation favors the borrower (who carries & pays back in deflated dollars.)How does inflation a bank loan favor the owner of the note?Curiously,Dave DonhoffLeverage Planner
Good post. Foreign currency investments are the best inflation hedge. US high yield and bank loans are very doubtful inflation hedges, particularly if you think inflation in excess of 6% is possible. At least if you own equities, you have businesses that make stuff that is increasing in price with inflation. If you own a high yield bond with a 7% coupon and inflation goes to 4-6%, I guarantee you won't feel very hedged.
The bond hawks have been worrying themselves silly about inflation in Japan for well over a decade because of their deficits. How's that working out? (Hint: interest rates under 1%)The Wall Street Journal and pundits of a particular persuasion have been carping about our deficits since the previous President pushed TARP and the car bailouts through, and rampant inflation doesn't seem to be on the horizon.Very few companies feel in a position to raise prices, although they may be forced to by commodity shortages from time to time (even then they mostly suck it up and try to wait it out), so - having lived through the inflation of the 70's, and being properly afraid of it, I also have to say that I was once in a car accident and still get in the car every day.Fear of a possible outcome, in the absence of evidence of a problem, is mostly a waste of time. When the markers start pointing in another direction, then ring a bell. We've been through greater and lesser inflation throughout our history, and only once or twice has it mattered to any significant degree in choosing assets.
goofy: "Very few companies feel in a position to raise prices, although they may be forced to by commodity shortages from time to time (even then they mostly suck it up and try to wait it out), so - having lived through the inflation of the 70's, and being properly afraid of it, I also have to say that I was once in a car accident and still get in the car every day."I just finished reading the reports on pg (which I have used as a bellwether for over a decade), cl and the summaries of the gdp report. It sounds like PG raised prices worldwide because of rising commodity prices and lost market share to companies like CL which also raised prices but less vigorously I suppose since CL gained market share. The gdp report talks about inflationary *pressures* but not a lot of actual inflation.I guess the Fed still sees deflationary pressures winning the tug of war based on their policies, and the fact that real wages are not showing much in the way of increases even as multinational corporations continue to try to squeeze a profit out of a combination of rising material costs and demand for cheaper stuff. I also guess that I am more interested in the posts that are devoted to studying the trail signs as opposed to arguing one side or the other and then looking for the trail signs to support the conclusions (if that makes any sense).
The strategies presented in Yoda's post have merit (easch for a different reason). Also, foreign currencies, bonds and equities may offer assistance.But before we arbitrarily grab at various assets simply because they are not US stocks/bonds we should evaluate the meaning of inflation.If all prices double, but everyone is paid twwice as much, we may have nominal inflation, but our standard of living has not changed. The problem is generally that not everyone's income rises equaly (one only has to look at retirees right now who are faced with ho to safefly deploy their funds, yet earn an income to rrealize this).It is not the numerical quantity of dollars that one has at any given time that matters, but rather the sustainable standard of living one can achieve. In this context, the way to balance inflation (simplistically a drop in the value of the US dollar) is with holdings which are not US dollar related. That said, unless inflation plunges us into a recession, I do not believe that there is necessarily the correlation with stocks going down that most project. The problem we previously faced was simultanious inflation and a rising US dollar (as other currencies inflated even faster).One of the value of evaluating one's assets in global terms is to determine the extent that inflation changes the global worth of your dollars.OT: BTW, in the midst of my extended trip I stuck another cruise (Celebrity Silhouette from Venice to Rome bouncing around the Adriatic for 12 days). I got a great price on a "guaranty" of at least a verranda cabin. Well, today I did a bit more research and the ship is so sparce, I was able to renegotiate the fare downwards. This is a pretty decent ship (larger than I prefer, but still a good reputation) and we are now paying less than $100 a person a night for at least a verranda cabin. This is less than the cost of a room in a 4* hotel, yet includes food, transportation, entertainment, etc. What it also shows is the stress that the cruise lines are under to try to fill their ships.JeffJeff
Hi Jeff,If all prices double, but everyone is paid twwice as much, we may have nominal inflation, but our standard of living has not changed.This would not be true for anyone carrying a loan, or owning income producing property, both of which would experience an increase in living standards (given all prices double and incomes match.)Cheers,Dave
The problem is generally that not everyone's income rises equaly (one only has to look at retirees right now who are faced with ho to safefly deploy their funds, yet earn an income to rrealize this). Jeff,Even people on indexed pay and pensions feel pain as the annual updates didn't keep up during the high inflation of the early 1970's. We actually had some junior married military on welfare to supplement their depleted salary. OT: BTW, in the midst of my extended trip I stuck another cruise (Celebrity Silhouette from Venice to Rome bouncing around the Adriatic for 12 days).You may be able to wave to the Costa Concordia on the way by... just don't go too close. }};-()Tim
yodaAs an investor in REITs since the 1970s (when there were few*), I carry in my mind that inflation is bad for REITs because of the higher cost of borrowing. I suppose the idea is that that rents rise too, but this is tricky because many REITs have long-term rent contracts (except for hotels).I'm inclined to believe that we are in a state of low inflation or deflation for many years. We are in a "Liquidity Trap" and no one knows how to get out of it. I'm sure that inflation, maybe even hyperinflation, will reappear at some point, but I sure don't know when as I have been expecting runaway inflation since 2001.When I bought 5-yr CDs at 5-6.5%, I feared these rates would be overtaken by inflation. Now these CDs are maturing and what can I get? I have a tradable CD that pays only 3.25% but that matures in 2022, and it is in the BLACK. We have a lot of corporate bonds that pay between 5 and 6.25%. Even though these bonds are callable, as you pointed out to me, they are yet to be called so I'll enjoy the coupons in the meantime. Most of these are with GE and BAC** that we held right through the "bad days" when there were those who thought both of these companies would fail. But so far they have paid the interest regularly. So on these we are standing pat.* How many on this board remember MONY Real Estate? How many recall when BRE was a diversified REIT and not an apartment REIT?** There eare certainly those who feel that BAC is still in big trouble as our bond with them pays 5.45% but is about 8% under water and has been much worse.brucedoe
Best Of |
Favorites & Replies |
Start a New Board |
My Fool |