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Inflation Nation (Part 2)

What does our low inflation environment mean for investors?

Core Personal Consumption Expenditure Deflator. Source: Department of Commerce

Inflation is an average. Prices in some areas are growing quickly, while others fall. That’s the way it has to be in a broadly diversified economy. The broadest measure of inflation - the personal consumption deflator - measures everything that consumers buy, and weights it by how much, then spend on those items. It measures substitution effects. So if the cost of cotton shirts doubles and everyone switches to synthetics, inflation wouldn’t change.

By contrast, the consumer price index measures the prices for a basket of goods - 40 thousand different items. That’s why I’m a little skeptical of folks who say that our low inflation numbers are wrong or manipulated. It would take a lot of skill to adjust that many inputs without everyone knowing about it. And outside analysis, like MIT’s Billion Prices Project, confirms the government’s data.

Monthly US Government and BPP inflation. Source: Pricestats

So if inflation is going to be low and stable for a while, how can investors adapt their portfolios and their expectations?

First, understand that bonds are a source of stability for a portfolio. For over three decades, we’ve been in an era of falling interest rates. For two decades prior to that, interest rates were rising. So during the past fifty years, bonds were either a drag on total return or a boost to performance. Now, they’re a source of stability. If investors will need periodic cash flows, bonds are a safe place to get this. Just don’t look for bonds to help your returns very much.

Next, focus on industries that are used to dealing with deflation. Deflation is a difficult business environment. Credit is hard to come by. If you build a factory, your products just

This article was written by

Douglas Tengdin, CFA is a portfolio manager and investment analyst living in Hanover, NH. He has worked in the investment industry since 1974, when started as a mail-boy for a regional municipal underwriter in Minneapolis, Minnesota. He has managed portfolios in Boston; Providence, Burlington, VT; and Tunis, Tunisia. He is currently the Chief Investment Officer for Charter Trust Company, a New Hampshire-based Wealth Management firm with over $1.6 billion in assets. His daily blog has been published since 2007. He has several radio shows around New Hampshire, and his daily thoughts are published on his web-site. He received his CFA Charter in 1992, and is an active volunteer with the CFA Institute. He was the founding President of the Vermont CFA Society.

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