Inflation: now and futures
Starting from tomorrow I will be making some changes in the real life portfolio.
Though most of it is focused on equities, some low-rated bonds did sneak in early this year. They had a good run but now is the time to slaughter these pigs. They have considerable upside left but the downside is greater.
I said it many times before and repeat it again: until the New Year at least we don't have to worry about inflation. But it may be smart to start worrying about inflation expectations, and these will be on the rise as the Krugmans fill up the media with "print, baby, print" sound bites.
I am a big fan of Rothschild and I like his idea of skipping the first and the last 20% of a price move.
Now, what about the real inflation that we should price in, and the chance for market inefficiencies?
Upon some thought, I come to the conclusion that Armageddon is not the cards, at least for now. We will not have double-digit inflation. John Paulson is wrong. Even 9% a year is far-fetched.
But if Paulson is wrong, that doesn't make Roubini right. Betting on deflation is even worse than betting on the double-digit horrors. My own educated guess, which will surely change as events unfold, is that for the next 5 years, we are most likely to see annualized 7% CPI increase in real life, and 5.5% CPI increase as reported officially.
That will be enough to wipe out the Treasuries crowd, but also to burst the gold bubble and teach commodity speculators a painful lesson.
If we accept my 7% estimate, then 10% yield on junk bonds will be reasonable. If investors choose to believe official inflation (or, to put it more accurately, if they choose to pretend they believe it), then 8.5% yield will be acceptable. If so, then most fixed-income ETFs must take a 20-25% haircut.
When the reality of inflation sips in, bond vigilantes will surely overreact. Then are now pricing in 3% inflation when they should be preparing for 5-7%. At the other extreme, they will brace for 10% when they should be preparing for 3-4%. At it is then when fixed income will become a good investment again. Will "Bernanke put" be offered to junk bond investors as it is now being offered for Treasuries only? In that case, I will not gain anything by selling now to buy back later, but I will not lose much either.
As Krugman is screaming that it's different this time, remember that while some things are different, others are not. The Fed's balance sheet is a coiled spring, ready to go at any moment. When the Blankfeins and the Dimons let it go as Bernanke chooses to look the other way, watch out.