Dividend Investors' Guide - Part IV - Inflation Or Deflation?

by: Mark Bern, CFA

Back to Part III - Beverage Industry

By Mark Bern, CPA CFA

If you are new to the series and would like to start at the beginning, just follow this link to "The Dividend Investors' Guide to Successful Investing." In the initial article I provide a description of my selection process and explanations of all the metrics I use. I am currently in the process of providing annual updates to the original industry articles. The beginning of the review process starts with an article reviewing the Food Processing Industry that can be found here.

In this article I have one intended goal: explain my views on whether I expect the future economic environment to be inflationary or deflationary. I have read many arguments on both sides of this debate. Personally, I don't really think it should be so much a debate than a reasonable acceptance of what appears to me to be obvious now.

Inflation or Deflation?

This is the question for which I found the answer allusive just one year ago and is the primary reason I stopped writing articles for almost a year. The answer was very important to me as it should be to all investors. Values of different assets will respond very differently depending upon the answer. Stocks could go up or down; bonds could tumble or merely return to normal levels; precious metals could rise to unprecedented levels or fall to lows not seen in a decade; real estate could become a hot investment again or fall to new lows. Of course, there is always something in between the extremes to consider, as well. So, I took some time off to do some research, reading, and ponder what the future is likely to hold for us.

I could write several articles on this subject but am disinclined to do so as such articles generally do not get many readers. Thus, I will provide a brief, but inclusive, summary of what I expect. I hope you will find my case for my expectations to be rational. If not, please provide your arguments and supporting reasoning in the comments section.

It makes sense to me to break my expectations down into three time periods: short-term, intermediate, and long-term. This is because I believe the environment will likely be different in each of these time frames.

Short Term

I define the short term period to encompass that period of however many months until the Federal Reserve begins to taper its quantitative easing (QE) program(s). The $85 billion that the Fed continues to drop primarily into the financial sector each month is the primary reason for the continued, albeit anemic, economic recovery we are experiencing. The second factor that is propping up the economy is the continuance of artificially low interest rates also orchestrated by the Fed. If Janet Yellen, President Obama's nominated heir apparent to replace Bernanke, survives the confirmation process to become the next Chair of the Fed, I would expect more of the same to continue possibly until the programs become completely ineffective. That could end in disaster. I hope that the other members of the Fed Policy Committee are able to dissuade her from such insanity. We will see.

In short, until the Fed diverts from its current policies I expect stocks to continue to trend higher for the immediate year and possibly into 2015 (assuming no significant policy changes before that).

Intermediate Term

It is important to note here that without all the QE and artificially low interest rate policy impacts, I believe that the U.S. economy would be experiencing deflation. The $85 billion per month that the Fed pours into the economy equals just over $1 trillion a year. In a healthy economy with a normal level of money velocity, such an unprecedented monetary injection would cause significant inflationary pressures. Some inflation (more than is being reported by our friends at the Bureau of Labor Statistics reports) is finding its way into the economy due to Fed efforts but the overall impact has been muted by the lack of monetary velocity. In other words, the money being pumped into the economy is not being put to work in productive ways. It is being used more for speculation in areas such as stocks.

But (there is always one of these onerous words in such strategic analysis - I can't help it; I have a background in economics) when the Fed programs are scaled down in the future, the true nature of our economic situation will show itself. To understand what that "true nature" is I went back to the one thing that has always worked for me in the past: the baby boomer generation. Over the past three decades those who could determine what the baby boomer generation was going to buy or consume next have been very well rewarded by their investments. Until the next significantly large generation hits a higher level of spending (probably not for another ten years) we are still stuck with what the boomers are doing as our best investment strategy.

I am of the boomer generation (near the leading edge) so I have personal experience (and much anecdotal information from many friends) that leads me to believe that overall consumption is likely to fall over the next few years. I know that Harry Dent has done significant research in this area and makes recommendations based solely on his projections of historical data of past generational spending patterns against the current and future generations. I agree with him to a certain degree but am not willing to concede the level of precision that he makes in his predictions based upon generalizations. The concept is sound, but the timing can be very difficult to ascertain, in my opinion. And his record supports my inclinations. He is usually right but his timing usually needs adjusting.

It has been my experience that once I retired and my wife retired we found ourselves with significantly less income than during our working years. Even though we paid down all debt except our home mortgage and saved diligently for retirement, we found ourselves needing to spend less than before.

One reason for this is that with interest rates so low, retirees are unable to produce the level of income from interest-bearing investments such as CDs or bonds as we had planned. It also does not help that stock dividend yields are still below historical averages. The final straw for many hoping to retire is that the equity that had built up in their primary home was gutted and the real estate market remains relatively soft in many areas. Downsizing is no longer as easy and does not provide the windfall that it once did.

Here are some scary quotes that lend support to my predictions of lower spending by boomer retirees:

From a new study by the National Institute on Retirement Security: "When all households are included - not just households with retirement accounts - the median retirement account balance is $3,000 for all working age households and $12,000 for near-retirement households."

"More than 38 million working age households (45 percent) do not have any retirement account assets, whether in an employer-sponsored 401 (NYSE:K) type plan or an IRA."

Depending on the source used, the average retirement savings of households that are near retirement and have retirement savings is somewhere between $100,000 and $255,000. The higher amount will not support an income much over $1,000 per month according to statisticbrain.com. Most pensions are less generous than in the past so the vast majority of the boomers are not likely to be able to keep up their spending habits.

If you still don't want to accept the reality of the situation then here is one more quote that should help:

"Among elderly Social Security beneficiaries, 23% of married couples and about 46% of unmarried persons rely on Social Security for 90% or more of their income." This is from the Social Security Administration at ssa.gov.

The point is that we are already in a deflationary environment and it is going to get worse. The Fed is just keeping the situation from spiraling out of control. When the Fed begins to taper significantly the natural forces of decreased consumption will cause deflation, unless….

The Fed may attempt to hold the economy out of the deflationary spiral beyond its ability to do so. If that happens, the US dollar could crumble and we would find our economy a shamble with high inflation.

Long-Term Outlook

Without the federal government (Congress and the Administration) helping out with reasonable fiscal policy reforms in many areas to create an environment that attracts jobs along with some restraint on deficit spending, I expect inflation to eventually rear its ugly head. I recall how everyone thought that inflation was so bad under Nixon at five percent. Then came the Carter Administration and inflation soared to new heights in the mid-teens. But with demand remaining somewhat stagnant for the next decade, we could have inflation somewhere in between (the proper term is stagflation). The big caveat comes from whether the US can retain its reserve currency status. If we lose that, then the lid is off on the inflation limits as the US dollar's value in global trade would plummet and everything we import would cost significantly more, and quickly.

I don't expect the US dollar to lose its reserve currency status any time soon, if at all. Currently, there just is not an acceptable alternative for most world trade. And there is no alternative to the US Navy keeping world trade routes open and safe. Take away reserve status and the US could no longer afford the luxury of the largest Navy in the world.

In summary, I expect little change (low inflation and rising stock values) in the months ahead, deflation to kick in sometime over the next two or three years, and either modest or rampant inflation to ravage our economy beginning sometime beyond 2020.

In the end, though, I still believe that our nation will weather these storms and come out the other end stronger. We have been through worse and we will come to our collective senses again at some point. It just seems we need to go through something awful before the right leaders step forward (and voters get fed up with the status quo) to clean up the mess created by those who came before.

Thanks for reading and, as always I enjoy your comments so keep them coming. Only through sharing our ideas, experiences and perspectives can we all learn to be better investors together. I wish you all a successful investing future!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.