YOUR INVESTMENTS: Inflation/deflation and your portfolio

As inflation rises, every dollar you own buys a smaller percentage of a good or service.

By AARON KATSMAN
August 18, 2010 23:32
4 minute read.
Aaron Katsman

Aaron Katsman 58. (photo credit: Courtesy)

 
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We always complain that prices we pay for goods and services are going up. Listen to the news and you hear that the price of bread is going up, as is the price of gas, not to mention the price of wheat, which has surged to a record high.

In fact, to escape the global economic slowdown, the United States, and almost every other country, is printing money around the clock to pay for the trillions of dollars in new government spending. Had you asked an economist a couple of years ago what would happen if the government printed money like this, you would have been told that inflation would be the result.

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We hear the term inflation bandied about, 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. As inflation rises, every dollar you own buys a smaller percentage of a good or service.

Funny enough, not only has inflation not materialized, but the same economic pundits predicting its arrival are now worried about deflation as the big economic hurdle of our time. Deflation is a decrease in the general price level of goods and services and results in an increase in the real value of money, allowing one to buy more goods with the same amount of money.

How did this reversal of fortune happen? According to the San Francisco Chronicle: “The first thing that happened was a recovery that wasn’t really a recovery. The United States has had a number of jobless recoveries over the past 20 years, but this one has been particularly dire and persistent. National unemployment continues to hover at 9.5 percent, and a fuller picture of unemployment and underemployment shows a full 16.5 percent of the workforce in need of a paycheck. Inflation isn’t possible when people don’t have any money to spend.”



What should we do?

It actually appears that we have both inflation and deflation happening simultaneously. Food and grain prices are moving higher, signaling inflation, but with little in the way of consumer spending or a pickup in employment, deflation seems to be the order of the day.

Confronting deflation

It’s clear from the recent market volatility that investors are unsure if inflation or deflation is going to win out. For investors there are things that can be done in both the short term and the long term to protect your portfolio against inflation and deflation.

For the next 12-16 months, I believe the focus will be on deflation. As such, investors may want to look at short term corporate bonds as an alternative to cash. Though you may only receive a yield of 1.5%-3% per year, in a deflationary climate, that is a very good investment. Remember, this would mean you have increased your purchasing power by this amount.

Secondly, preferred stocks with much higher yields also can be incorporated into your portfolio, but be sure to keep your finger on the sell trigger, because once interest rates start moving higher, preferred stocks can potentially drop in value.

Thirdly, in deflationary times, the US dollar is viewed as a safe haven.

Confronting inflation

Once the economy stabilizes and starts to grow again, then investors should be on the lookout for inflation. No government can constantly print money and create unsustainable debts and escape some kind of inflation. As a hedge for inflation, investors can look to invest in gold, which is probably the most popular inflation hedge.

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%.”


If inflation were to take hold, the US dollar would probably take a big hit. As such, foreign-currency bonds (i.e., nondollar bonds) would be a good hedge against a falling dollar. These bonds offer higher interest rates than the dollar, and their local currencies would appreciate against the dollar, allowing for capital appreciation as well.

aaron@lighthousecapital.co.il

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

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