Preparing for the Inevitable Inflation

Months ago rating agency Moody’s warned that the U.S. Government was at risk of losing its prized AAA credit rating. In May, Bill Gross, head of PIMCO, the world's biggest bond shop, warned that the United States will eventually lose its top AAA credit rating. Also in late May, Moody's said it is comfortable with the current AAA rating on the United States, but it is not guaranteed forever. Steven Hess, lead analyst for Moody's:

There are longer-term pressures on the rating, that's very clear.

So, is the U.S. at risk of losing its AAA credit rating?

In a June 4, 2009, article titled "Inflation, Not Default, Is Risk for Treasury Bonds", respected author Jeremy Siegel, Ph.D., says that the US cannot technically default on its bonds. Siegel wrote:

Is it possible for the U.S. government to default on its own debt?
Technically, the answer is "no." The government can always print the money to pay its obligations. But from an economic standpoint, the answer is "yes," since printing money causes inflation and pays off bondholders with depreciated dollars. [Emphasis mine]

Describing the conditions that cause inflation, Siegel said:

In a fiat money standard, money only retains its worth because the government limits its supply. The government can limit its supply if it has other sources of revenue, such as taxes or borrowings, to cover its expenditures. But if those other sources dry up, the government may effectively borrow from the Fed, and this would result in large increases in money and rapid inflation.

Sounds like exactly what is happening today. Future inflation is certainly possible, but not inevitable, Siegel goes on to say:

Since the credit crisis began, the Federal Reserve has more than doubled the supply of its own money, and government deficits are running into the trillions of dollars. Many believe this will inevitably lead to rapid inflation.
But such a conclusion is premature. The Fed has increased the supply of money in response to the tremendous increase in the demand for such money caused by the liquidity crisis. And government borrowing is just offsetting the sharp increase in consumer saving caused by the declining value of assets and tighter credit.

Siegel's gives two steps that must happen in order for inflation to be prevented: Here is Siegel's Step One:

Once confidence returns, the Fed must pull back the money it loaned and the government must bring deficits under control. This will inevitably mean raising interest rates, and the latest increase in long-term treasury rates is a clear signal that the bond market sees this happening soon.

Given the enormous debt load faced by this country, the declining tax revenues, the future looming Medicare and pension obligations that greatly pressure the deficit (or increase taxes), and the increases in spending proposed by the current administration, I cannot see how the government can bring it's deficits under control in the near term.

Below is Siegel's second step that must happen in order for inflation to be prevented:

If, by the second half of this year, the economy turns around, the Fed will have to start raising the Fed Funds rate and restrict liquidity. Otherwise the government will effectively default on its obligations -- not by missing its payments but by making those payments in a depreciating currency.

Yes, the Fed has all the tools at its disposal necessary to prevent inflation. The problem is that many recoveries are jobless recoveries. Because the Fed is specifically mandated, by law, to keep employment levels high, it will face an enormous battle if it tries to raise interest rates. I disagree with Siegel's optimistic outlook.

The Power of Compounding

Back in 1967, Alan Greenspan said:

"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. … This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process… It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard."

Alan Greenspan served as Federal Reserve chairman from August 1987 until January 31, 2006. Despite his belief that inflation amounted to robbery, Greenspan engendered benign inflation during his tenure.

A (benign) inflation rate of 3.5% over 19 years yields a total of 92% inflation, halving the value of the dollar. Additionally, if the government fudges the CPI by a mere 1% - then 3.5% inflation becomes a real 4.5% rate of inflation. Over the same 19 year span you get 231% inflation, reducing the dollar to only one third of its 1987 value. Due to the power of compounding (aided by government fudging of official CPI): there is no such thing as benign inflation.

Despite the authorities claim that 'inflation will be controlled' - every investor should defend their portfolio from inflation. This is especially true in 2009. But it was also true in 1999, 1989, 1979, and 1969. Today, the risk of inflation is even greater and Investors should have a rock-solid way to protect their wealth.

Asset Classes That Will Get Hammered By Inflation:

• Cash, Bonds, Annuities and preferred stocks.
• If the inflation becomes global, rather than local, then the same instruments denominated in foreign currencies will also bit hit.

Asset Classes That Are Inflation-Protected

• Inflation-protected securities (WIP), (TIP).
• U.S. and Foreign Equities and REITS, especially the stocks of Commodity-Producers (Oil, Gas Companies with product in the ground)

DISCLOSURE: Author is long VNQ, U.S. Equities, Non-U.S. Equities, Emerging Markets Equities, US TIPS and WIP. You should perform your own due diligence and consult with a professional before investing.

Comments

[Donald Ingram:]

Ludwig von Mises said it years ago, " There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crises should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
That catastrophe will be hyperinflation, leading to a worthless currency.
Reevaluation then occurs. 1 'new' dollar for 1,000 'old' dollars?
Debt will be gone.
All savings gone.
Foreign reserves of nations gone.
All dollar denominated wealth or dollar backed assets gone.

Jun 09 12:59 PM

[Living4Divi...:]

So True. Donald, So True. Thanks for your comments. I agree with you Ludwig Von Moses. Bigtime inflation is in our future. I am not sure if hyper inflation is coming, but inflation for sure.

On Jun 09 12:59 PM Donald Ingram wrote:

> Ludwig von Mises said it years ago, " There is no means of avoiding
> the final collapse of a boom brought about by credit expansion. The
> alternative is only whether the crises should come sooner as the
> result of a voluntary abandonment of further credit expansion, or
> later as a final and total catastrophe of the currency system involved."
>
> That catastrophe will be hyperinflation, leading to a worthless currency.
>
> Reevaluation then occurs. 1 'new' dollar for 1,000 'old' dollars?
>
> Debt will be gone.
> All savings gone.
> Foreign reserves of nations gone.
> All dollar denominated wealth or dollar backed assets gone.

Jun 09 01:39 PM

[Pink Panther:]

One more thing to consider:
Historically during the onset of inflation, equities got hammered badly (equity earnings get measured versus bond yields, which are rising).
After that drop in price, equity earnings yields were roughly the same as bond yields but the principal - the price of the equity or bond - only was inflation protected with equities.
Plus, when inflation goes away, equities usually soar back in price.

Therefore it's better to prepare for inflation using commodities (i.e. precious & base metals, agriculture) before commodity producer stocks (these have a certain correlation to the underlying commodity but also a large correlation to the overall stock market).
Once the stock market has dropped on inflation, equities with inflation protected underlying earnings stream are the way to go.

Jun 09 01:40 PM

[Pink Panther:]

There's a big qualitative difference between inflation and hyperinflation:
Inflations happens, when caused by an increase in money supply and/or increased velocity of money, more money chases less goods. Fortunately higher prices causes demand to drop, thereby lowering prices - a negative feedback loop.
Inflation would be a sign of an improving economic environment.

Hyperinflation on the other hand is caused by loss of confidence in a currency, i.e. the dollar. In this scenario, investors try to get rid of the currency as quick as possible, hereby causing a drop in its value, which causes even more investors to drop that currency - a positive feedback loop ending in disaster.
Hyperinflation does not need an improving economic environment, it could happen even amidst a deep crisis!

> Bigtime inflation is in our future. I am not sure if hyper inflation is coming, but inflation for sure.

Jun 09 02:08 PM

[Living4Divi...:]

Interesting point. Yes, equities do poorly at the beginning of inflation. Bonds do even worse. As for the commodities are better than equities, during inflation - this is an interesting idea. Do you have any long term studies you can direct me to?


On Jun 09 01:40 PM Pink Panther wrote:

> One more thing to consider:
> Historically during the onset of inflation, equities got hammered
> badly (equity earnings get measured versus bond yields, which are
> rising).
> After that drop in price, equity earnings yields were roughly the
> same as bond yields but the principal - the price of the equity or
> bond - only was inflation protected with equities.
> Plus, when inflation goes away, equities usually soar back in price.
>
>
> Therefore it's better to prepare for inflation using commodities
> (i.e. precious & base metals, agriculture) before commodity producer
> stocks (these have a certain correlation to the underlying commodity
> but also a large correlation to the overall stock market).
> Once the stock market has dropped on inflation, equities with inflation
> protected underlying earnings stream are the way to go.

Jun 09 05:29 PM

[user396040:]

Equities do not necessarily do well in a period of high inflation. During the late 1970s/early 1980s, the equity market was hammered because interest rates got very high and investors demanded high dividend yield and high earnings yield in the equity market; mathematically, this translated into low PE and low price dividend ratios. Oil stocks were somewhat of an exception, but, oddly enough, as inflation balooned, we had the same kind of flight into short term debt instruments that we had this past Fall. The big different was that you could earn between 15 and 20 percent interest on a money market account in those days. People confidently predicted that we would never return to single digit mortgage interest rates; I had an 11% mortgage and the bank offered to let me pay it back at a discount so that it could redeploy the capital at a higher interest rate.

Jun 09 06:52 PM

[Living4Divi...:]

True, the 70's were not kind to stocks.

Equities do well during the beginning of inflation. They get hammered at first, then adjust. I base my beliefs on the long term studies I have read (Siegel) comparing the performance of stocks during inflationary periods. I do not think inflation is fundamentally good for stocks. I think of equities as a safe haven, in that they represent real assets: factories, buildings, plant equipment. This stuff holds it value during inflation.

Long bonds will get hammered. During inflation, equities are a better bet than bonds.

One could stay in short term cash, paying zero interest and wait for interest rates to pick up. But cash also gets hammered by inflation while you are waiting.


On Jun 09 06:52 PM user396040 wrote:

> Equities do not necessarily do well in a period of high inflation.
> During the late 1970s/early 1980s, the equity market was hammered
> because interest rates got very high and investors demanded high
> dividend yield and high earnings yield in the equity market; mathematically,
> this translated into low PE and low price dividend ratios. Oil stocks
> were somewhat of an exception, but, oddly enough, as inflation balooned,
> we had the same kind of flight into short term debt instruments that
> we had this past Fall. The big different was that you could earn
> between 15 and 20 percent interest on a money market account in
> those days. People confidently predicted that we would never return
> to single digit mortgage interest rates; I had an 11% mortgage and
> the bank offered to let me pay it back at a discount so that it could
> redeploy the capital at a higher interest rate.

Jun 09 07:13 PM

[Pink Panther:]

Living4Dividends wrote:
> Interesting point. Yes, equities do poorly at the beginning of inflation. Bonds do even worse. As for the commodities are better than equities, during inflation - this is an interesting idea. Do you have any long term studies you can direct me to?

I use Robert Shiller's data for this kind of studies:
www.irrationalexuberan...
There you'll find the Excel file with the data on S&P 500 stock prices, earnings, dividends and interest rates since 1871. In this file, there's also the CPI as the indicator of inflation and the inflation adjusted "real price" of the S&P 500.

The periods to look for are 1917-1920, 1941/1942, 1946/1947, 1973/1974 and to a smaller extent 1970 & 1979-1981

Jun 10 01:27 AM

[Pink Panther:]

As for how commodities performed vs equities & corp. bonds during the inflationary 70's, here's an interesting article:
www.cxoadvisory.com/bl.../

Jun 10 01:44 AM

[Living4Divi...:]

Thanks Pink Panther, I'll check out.


On Jun 10 01:44 AM Pink Panther wrote:

> As for how commodities performed vs equities & corp. bonds during
> the inflationary 70's, here's an interesting article:
> www.cxoadvisory.com/bl.../

Jun 10 11:11 AM

[Living4Divi...:]

Pink Panther,Thank you also for the link to the Shiller data

Jun 10 11:12 AM

[mbkelly75:]

I also think that inflation is a given but I am not sure how good TIPs and WIP are going to be. If the govt. fudges the inflation rate to make it seem less - they will pay less on these than they should. It is a good article and I thank you for your work on it and agree with the main premise of it if not with all the recommedations. PinkPather - thank you for the links. I found them very helpful. ETFs have made investing in both Commodities and Bonds MUCH easier now than they were when I got started in investing over 50 years ago. It is now very easy to keep them in an easily tradable form as a part of a balanced portfolio and re-balancing when needed is equally easy now. DBA, JJA and RJA are all ETFs that track Commodities - RJA tracks 20 different ones. These make it easy to use Commodities in a portfolio without having to learn futures trading. They are worth a look.

Jun 10 01:28 PM

[Alphameister:]

I have the greatest respect in the world for Von Mises, but there is a third alternative that has become the policy prescrption of the current powers in DC. It involves avoiding both an immediate collapse and a more distant hyper-inflationary debacle by spreading out the pain of de-leveraging over a period of many years. I'm guessing the Fed will eventually settle for an inflation rate on the order of 4% to 5% to provide a cushion against the much-feared deflation while also enabling debts to be re-paid with moderately cheaper dollars. I also expect a rising chorus of demands to remove from the Fed such "independence" as it still claims to possess.

Jun 10 05:41 PM

[yellowhoard:]

TIPs are a lousy way to protect yourself from inflation.

The government gets to decide the "official" inflation rate, so you know it's BS.

Wow, Intel has a chip that's twice as fast as the last at the same price. Forget about food and fuel, nobody uses them.

Then, you get to pay taxes on your TIP each year.

Commodities are more effective. Buy DBA or DAG or DYY, etc...
and forget about em for a few years.

Jun 10 06:16 PM

[jhartz:]

Pennies! In the end, those that have American cents will still have something of value. Don't know what the copper content of recently minted pennies is, but I'm willing to bet it will be worth far more than one hundredth of a paper dollar in the near future.

Save your pennies and enjoy the emotional rush you'll have the first time you buy a sack filled with apples for three or four copper clad pennies.

Jun 10 09:23 PM

[Living4Divi...:]

On Jun 10 06:16 PM yellowhoard wrote:

> The government gets to decide the "official" inflation rate, so you
> know it's BS.
>
> Wow, Intel has a chip that's twice as fast as the last at the same
> price. Forget about food and fuel, nobody uses them.
^^^^^^^^^^^^^^^^^^^^^^...

LOL! Yellowhoard I always enjoy your comments, you are a riot. Sadly, it's somewhat true. They are fudging the inflation figure. The controversy is: " by how much are they fudging the inflation? "

> Then, you get to pay taxes on your TIP each year.
>

True. TIPS suck in a taxable account.
Suppose that inflation is 4% and the coupon is 2%. You have to pay 33% taxes on both the inflation adjustment and the interest. 33% of 6% is 4%. Guess what, you've just kept up with inflation. And if US CPI is fudged by 1%, as I suspect, you are upside down by 1%. That's why TIPS only make sense in a sheltered account.

So you have a government which prints massive money, causing inflation. Then all your assets go up in nominal terms but not in real terms. Then you have to pay taxes on the capital gains that were artificially generated by inflation. It's called the inflation tax. And it sucks.

Jun 10 09:53 PM

[Living4Divi...:]

I read somewhere (may be a myth) that during the height of the commodity boom that pennies were worth more than 1 cent each - for their copper content.

The law prohibiting melting down pennies for their copper content is the only thing that saved the penny from disappearring.

On Jun 10 09:23 PM jhartz wrote:

> Pennies! In the end, those that have American cents will still have
> something of value. Don't know what the copper content of recently
> minted pennies is, but I'm willing to bet it will be worth far more
> than one hundredth of a paper dollar in the near future.
>
> Save your pennies and enjoy the emotional rush you'll have the first
> time you buy a sack filled with apples for three or four copper clad
> pennies.

Jun 11 07:21 AM

[Steve in Gr...:]

Thanks, L4D, for a nice overview. I share the concerns of the other authors about equities during an inflationary period (e.g. the Carter years) and about past and ongoing manipulation of inflation statistics to reduce the TIPs cost to the government. There will be massive USD inflation and USD devaluation and I'm not doing U.S. equities or TIPs in response. The rest of your recommendations are sound, I think.

But I was dumbfounded by the following comment by Alphameister...

On Jun 10 05:41 PM Alphameister wrote:

"...there is a third alternative that has become the policy prescrption of the current powers in DC. It involves avoiding both an immediate
collapse and a more distant hyper-inflationary debacle by spreading out the pain of de-leveraging over a period of many years...."

While the private sector is trying to deleverage, the current government (including the Fed) is aggravating the problem of excessive leverage by 1) running huge and increasing deficits and 2) inflating the supply of USD . I am convinced the current government does not care about the collapse of the USD and inflation that they are guaranteeing by their actions today. Those are problems for another day, as far as they are concerned. As a result of their wrong-headed policies (deficit spending and currency debasement), they will create a much bigger problem than the one we have today.

Jun 11 09:19 AM

[Pink Panther:]

You're all very welcome. It's great about this site, that we all can
learn from each other a lot!
Keep in mind that for a long term portfolio you need to chose a commodity index which copes well with contango losses:
Bad (rolling monthly): GSCI, DJ-AIG, Reuters CRB, USO
Good (improved roll strategy): The DB Indices (DBA), (DBB), (DBC), CMCI
I don't know about the strategy of (JJA) or (RJA)

Living4Dividends wrote: > Pink Panther,Thank you also for the link to the Shiller data

On Jun 10 01:28 PM mbkelly75 wrote:
> PinkPather
> - thank you for the links. I found them very helpful. ETFs have made
> investing in both Commodities and Bonds MUCH easier now than they
> were when I got started in investing over 50 years ago. It is now > very easy to keep them in an easily tradable form as a part of a
> balanced portfolio and re-balancing when needed is equally easy now.
> DBA, JJA and RJA are all ETFs that track Commodities - RJA tracks
> 20 different ones. These make it easy to use Commodities in a portfolio
> without having to learn futures trading. They are worth a look.

Jun 11 03:10 PM

[user396040:]

I think you are right in the long term. In the short term, inflation means higher interest rates which in turn should mean lower price earnings ratios. However, in the long term, inflation will definitely increase nominal gross revenue of companies as well as nominal earnings and nominal dividends. And in the long term, these effects will swamp the effect of the lower price earnings ratio. Since 1940, prices have gone up roughly ten fold and so have corporate earnings, dividends, and stock prices.

On Jun 09 07:13 PM Living4Dividends wrote:

> True, the 70's were not kind to stocks.
>
> Equities do well during the beginning of inflation. They get hammered
> at first, then adjust. I base my beliefs on the long term studies
> I have read (Siegel) comparing the performance of stocks during inflationary
> periods. I do not think inflation is fundamentally good for stocks.
> I think of equities as a safe haven, in that they represent real
> assets: factories, buildings, plant equipment. This stuff holds it
> value during inflation.
>
> Long bonds will get hammered. During inflation, equities are a better
> bet than bonds.
>
> One could stay in short term cash, paying zero interest and wait
> for interest rates to pick up. But cash also gets hammered by inflation
> while you are waiting.

Jun 11 05:31 PM

[Living4Divi...:]

Hi Steve in G'boro - Thank you for the compliment - you are very welcome. And thanks for your comments - very good.


On Jun 11 09:19 AM Steve in Greensboro wrote:

> Thanks, L4D, for a nice overview. I share the concerns of the other
> authors about equities during an inflationary period (e.g. the Carter
> years) and about past and ongoing manipulation of inflation statistics
> to reduce the TIPs cost to the government. There will be massive
> USD inflation and USD devaluation and I'm not doing U.S. equities
> or TIPs in response. The rest of your recommendations are sound,
> I think.
>
> But I was dumbfounded by the following comment by Alphameister...
>
>
> On Jun 10 05:41 PM Alphameister wrote:
>
> "...there is a third alternative that has become the policy prescrption
> of the current powers in DC. It involves avoiding both an immediate
>
> collapse and a more distant hyper-inflationary debacle by spreading
> out the pain of de-leveraging over a period of many years...." <br/>
>
> While the private sector is trying to deleverage, the current government
> (including the Fed) is aggravating the problem of excessive leverage
> by 1) running huge and increasing deficits and 2) inflating the supply
> of USD . I am convinced the current government does not care about
> the collapse of the USD and inflation that they are guaranteeing
> by their actions today. Those are problems for another day, as far
> as they are concerned. As a result of their wrong-headed policies
> (deficit spending and currency debasement), they will create a much
> bigger problem than the one we have today.

Jun 18 07:52 AM