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Investing for Higher Inflation

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April 27, 2012 – Comments (4)

Board: Macro Economics

Author: yodaorange

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:

TIPS
Commodities
REITS
Emerging market debt
High yield aka junk bonds
Bank loans

The 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...

4 Comments – Post Your Own

#1) On April 27, 2012 at 2:18 PM, Mega (99.95) wrote:

The problem is that TIPS, most US REITs, and many commodities already appear aggressively priced, without much apparent upside.

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#2) On April 28, 2012 at 10:23 PM, commoncents33 (< 20) wrote:

I think the best investments in any scenario is to own fractions of wonderful businesses (e.g., high return on invested capital) with durable moats, purchased at a reasonable price.

 To help mitigate the problem of a single currency tanking, owning wonderful businesses which have their earnings scattered widely abroad is wise.

 Moreover, finding great businesses at attractive prices (while a challenge) is far, far easier than trying to guess correctly on a multitude of macroeconomic factors and their timing.

 

p.s.  The big, big problem with TIPS is that the same government which promises you "inflation adjusted" returns is the same government that defines what the level of inflation is.  No conflict of interest there! 

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#3) On April 29, 2012 at 4:37 PM, leohaas (35.73) wrote:

If you believe that "This Time Is Different", then back testing loses all value!

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#4) On April 29, 2012 at 5:12 PM, whereaminow (42.76) wrote:

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?”

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And that's why TMF Morgan Housel has no credibility speaking on economic issues.

Since I've covered these topics a dozen times or more, I'll keep it simple. There's the Cantillon Effect of money creation, where the first users of new money benefit. There's the malinvestment that arises when credit creation does not match consumer time preference.  There's the moral hazard that comes from having a lender of last resort. There's the growth of government that occurs when governemnt can borrow at will from the (consumer) Fed, driving up costs for everyone - especially damaging for the poor.  And we could go on and on. 

David in Liberty

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