Inflation (or Lack Thereof)

March 2, 2010

Fear of inflation has remained strong since our last bout of high inflation three decades ago. The fact that inflation has steadily gone down during most of this period hasn’t put fears of the Great Inflation Monster back into the closet. 

Inexplicably, investors are more afraid of runaway inflation than depressions or panics, although both have occurred more frequently in our nation’s economic history. Even during this last face-off with possible depression, most investors were more concerned about inflation than deflation, perhaps the main symptom of an economic depression.

Investors often misunderstand inflation, or worse, take steps to "protect" themselves, which causes even more problems. In recent years, investors have grown more fearful of inflation. Since we believe no lasting investing fortunes have been made doing what everybody else thinks is a good idea, it’s high time to review the logic behind irrational inflation fears.

Our dollar gets a little less valuable each year (except for a brief period during the recent recession in which it became a bit more valuable and a period in the Great Depression where it became much more valuable). Ignore the wilder fluctuations between the dollar and other currencies, which tend to swing up and down, but over time go sideways, and think about the actual purchasing power of the U.S. dollar each year. It goes down slowly but steadily, like most currencies.

This feature of our currency is often held up as proof of the dangers of inflation, and in some cases, the overall decline of America. One wonders how our economy grew so much over the last century in face of such an embarrassing slide of our greenback?

Currencies grow less valuable by design. The government makes more of them every year for a variety of reasons, most of which make good economic sense. Rather than delve into the complexities of the expanding money supply, let’s just consider the opposite scenario — in which the dollar grows more valuable year after year, and is worth more in five years than it is today.

In such a scenario, which some pundits would herald as proof of the soundness of our economy, it would make sense for investors to hoard dollars. Why invest and take risks when you're guaranteed to enjoy a positive return by merely stuffing cash in a safe at home? If everyone did this, the economy would grind to a halt, since there would be no money left in the banks to lend out (no jokes about lending to No-Doc homebuyers, please!).

Suffice it to say the opposite is better. A slow decline in currency is good for the economy, if for no other reason (and there are other reasons) than it encourages people to either keep their money in the banking system or invest it. In fact, one of the dangers of the current government policy of low rates is just that — the population hoarding currency because yields on money markets, short-term CDs, and the like are essentially zilch. The other risk is taking too much risk in an effort to boost yield.

The first takeaway when investing in a world of steady low inflation is that you can’t invest in currencies themselves.  Since short-term CDs and money market funds have done a fine job of beating inflation over time, staying ahead of this slow erosion in purchasing power is safe and easy. You don’t need an inflation-beating strategy in the long-term for your short-term safe money. Even the anemic yields on shorter-term investments in the last few years have kept pace with inflation, largely because inflation has been almost non-existent. Commodities have had far more trouble keeping pace with inflation since our last major bout with inflation.

Inflation will kill the stock market. That’s another zinger we always hear, largely based on the 1970s when stocks went nowhere for a decade and inflation zoomed ahead. Of course, we just had a decade of no gains in stocks, and inflation was about as low as it’s ever been. The Great Depression and ensuing 90% peak-to-trough hit to stocks was marked by years of ensuing deflation, not inflation. The inflation-mongers tend to use selective proofs of the dangers of inflation.

Inflation is a general increase in the price level of just about everything, including wages. In such an environment, stock prices should inflate along with everything else. If we had 100% inflation over a few years, Apple would be able to charge 100% more for an iWhatever, and earn 100% more as well. 

Although there are some dangers from wild swings in inflation and resulting borrowing cost increases for some companies, the risk of inflation singlehandedly destroying stock prices is overrated. What receives less attention is the real reason stocks went nowhere in the 1970s – that they actually did go somewhere. They went from being very overvalued after the go-go 1960s markets to being very undervalued. That's what happened in the 2000s as well.

Longer-term stock returns usually stink when investors bid the prices up too high during periods of stock infatuation. Inflation, if it has any impact, is one reason investors fear stocks. But then, there's always some reason stock (or any asset) prices decline from overvaluation. The problem isn't the straw that broke the camel’s back. The problem is the big pile of straw. 

When home prices began to collapse, the fall was blamed on the mysterious subprime problems, as though homes being as much as 100% overpriced from historical valuations had nothing to do with the crash. It was all blamed on someone with bad credit buying a $150,000 condo. 

Homeowners do fine with inflation as well. For those that have a fixed-rate mortgage on a home (or homes,) there is NO BETTER scenario than inflation picking up. Your home, the asset, will inflate, while the debt, the liability, will become a smaller and smaller percentage of the home’s value. Moreover, the earnings from real estate (the rent) will climb as well. 

Imagine buying a $300,000 home with no money down and a fixed-rate interest-only mortgage and then experiencing 100% inflation over the next five years. You’d be sitting pretty at year five, with a $600k home and a $300k loan. Our real estate market would be in far better shape if we'd had a good dose of inflation in recent years.

The funny thing is, experts never recommended buying a home as a hedge against inflation. For some reason, commodities are considered the inflation hedge we all need. If you have a $500,000 portfolio of stocks and bonds, how much would have to be allocated to commodities to protect you, anyway? Fifty thousand? 

Let’s say we have 100% inflation. You might earn $50,000 if commodities prices double. Would that even cover your losses on the bond side? Compare that to putting 20% down, or $20,000, on a $100,000 condo. If we had 100% inflation, you'd have $100,000 in profits on your $20,000 investment, AND the rent you could charge on your condo would have doubled. Can commodities ever touch that? Of course, a leveraged real estate investment can become worthless with serious deflation, while commodities would merely fall hard.

Some probably think if we have inflation, commodities would go up far more than the rate of inflation, but such an explosive gain would be short-lived, as commodities are part of inflation, and can’t outpace the inflation rate for long.

Inflation benefits those who own assets, including stocks and real estate. However, it's not great for everyone. Inflation hurts lenders. If you buy a bond, you're a lender. The risk is you'll be paid back with inflated dollars. Fortunately, since interest rates tend to be higher than inflation, it would take a pretty big move up in inflation before bond investors got clobbered, but this is the area of your portfolio to watch if inflation ever takes off.

One solution is shorter-term bonds, CDs, etc., because you could simply buy new higher-yielding investments as inflation takes off. The risk here (one most investors are familiar with, including us) is you'll sit around earning very little waiting for inflation and interest rates to take off, meanwhile missing the higher yields on longer-term bonds and CDs. More has probably been sacrificed owning short-term debt as a hedge against inflation and rising rates than has actually been lost due to inflation over the years.

For those still anxious, there are TIPS, or Treasury Inflation-Protected Securities, which offer a guaranteed return over inflation. The trouble here – and we own some in our Powerfund Portfolios – is a little overvaluation. Honestly, if inflation stays under about 2%, you'd fare better in ordinary government bonds. Still, for those who remain concerned about inflation and are too risk-averse to take larger stakes in stocks or real estate, TIPS offer a way to definitively beat inflation. TIPS aren't like commodities, which could just as easily match inflation (or even worse, tank).

Remember, the government invented TIPS to LOWER their borrowing costs, not raise them. It realized it was paying an artificially high rate on Treasury bonds because investors irrationally fear inflation and demand higher rates in order to buy the bonds. Since the government controls inflation, it realized it could save money by taking this often ungrounded fear out of the picture.

If inflation is bad for long-term bond investors, deflation must be good, and it is (provided the person you lend to can pay you back, which many won’t be able to do if we experience major deflation like that seen in the Great Depression). 

That's one reason why government bonds fared well during the panic of 2008 . The government will pay you a paltry 3% yield back along with your principal, unlike some leveraged company which pays a higher rate but may have trouble making the payment should the economy seriously tumble.. 

The future we fear in our portfolios is deflation, not inflation. Deflation can be a tough villain to slay, as Japan demonstrated in their roughly two decade-long battle with deflation. Deflation appears to be easy to beat. Just print more money. However, a sliding economy generates its own deflationary forces that are hard to counterbalance. 

Inexplicably, investors are not as afraid of deflation, despite the fact the Japanese stock market is still down about 75% from its peak two decades ago. Half the reason we’ve owned Japanese funds in our portfolios is based on our expectation inflation will resume – a good thing.

Meanwhile, we’ll keep worrying about the things that are off other investors' radar.