Your Investments: Fiscal cliff, inflation and gold

As I predicted, an agreement was reached in Washington to avoid falling off the fiscal cliff. The “all clear” siren was sounded, so feel free to put away your parachutes. We are being led to believe that this agreement will help put the US back on stable economic ground, and the rest of the world’s global players are also breathing easier because Armageddon was averted, and I am not talking about the Mayans.

The problem is that the solution reached is similar to Wile E. Coyete’s method of falling off a cliff: It’s all is good until you look down!

Raising taxes on those earning over $400,000 a year generates enough money to run the government for a matter of days. With more than $16 trillion in debt, nothing can possibly be done to put the US economy on solid footing other than make budget cuts and grow the economy. In fact the Congressional Budget Office scored the new legislation and said it would add more than $3.9t. to the debt over the next decade. Heck of a solution!

We are always complaining that the prices we pay for goods and services are always going up. Listen to the news and you will hear that the price of electricity is going up, as is the price of gasoline. In addition, to escape the economic slowdown that has gripped the world, the US and almost every other country is printing money 24 hours a day, seven days a week to meet the trillions in new government spending.

We hear the term “inflation” thrown around, but what is it and how does it impact our investments?

What is inflation?

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service.

The value of a dollar does not stay constant when there is inflation. The value of a dollar is observed in terms of purchasing power, which is the real, tangible goods that money can buy. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 2 percent annually, then theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your dollar can’t buy the same goods it could beforehand.

Inflation and investment

The government’s readings may point to low inflation due to their calculation process. With all due respect, we have data that shows the economy is inflating. Just go to your supermarket.

If it appears that we are going to enter a period of high inflation, and what we said above is true that inflation erodes the purchasing power of your money, the question for investors is how to protect your portfolio against a spike in inflation? There are two ways that I’d like to highlight. The general principal is to buy something now and sell it later – after inflation has increased the price of the product.

The most popular hedge against inflation is to buy gold. Most of my clients know that I am no lover of gold. Aside from the last decade, gold as a long-term investment is no great shakes. But if there is no will to trim the debt, at some point in the next few years the dollar’s decline will accelerate, and gold will benefit.

According to Blanchard Economic Research: “Gold is renowned as a hedge against inflation. The most consistent factor determining the price of gold has been inflation – as inflation goes up, the price of gold goes up along with it. Since the end of World War II, the five years in which US inflation was at its highest were 1946, 1974, 1975, 1979 and 1980. During those five years, the average real return on stocks, as measured by the Dow, was -12.33%; the average real return on gold was 130.4%.”

In recent times the use of commodities aside from gold has gained in popularity. Corn and wheat are just some of the other base commodities that increase in price during inflationary periods.

Don’t wait for inflation to arrive to start thinking about protecting your portfolio – because by then it may be too late. Get a head start now and protect the value and purchasing power of your money.

Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.

aaron@lighthousecapital.co.il