Your Investments: Inflation and your portfolio

What is inflation and how does it impact our investments?

November 29, 2012 06:12
3 minute read.
Tel Aviv brokers

Tel Aviv brokers. (photo credit: REUTERS)


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Doesn’t it seem that prices are always on the rise, except for when Rami Levi opens a new store and suddenly you can buy chicken for NIS 1 a kilo. Listen to the news and you will hear that the price of tomatoes is going up, as is the price of gas, not to mention the price of wheat, which has surged to record-high prices.

In order to escape the global economic slowdown, the US and almost every other country have been running the printing press 24 hours a day, seven days a week, to pay for the trillions of dollars in new government spending.

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Had you asked an economist a couple of years ago what would happen if the government printed money like this, the economist would have said, “inflation.”
What is inflation and how does it impact our investments?

Definition of 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.

Now, 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.”

Things have improved slightly, but we still don’t see any real signs that inflation is coming.

I would say that until we start seeing unemployment drop to 7%, we will not start to see wage inflation, or inflation in general.

What to do?

It’s clear from the recent market volatility that investors are unsure of which “ation” is going to win out. I think that for the next 12 to 16 months 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.

Also, preferred stocks with much higher yields 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. And thirdly, in deflationary times, the US dollar is viewed as a safe haven.

Once the economy stabilizes and starts to grow again, investors should be on the lookout for inflation. No government can constantly print money and create unsustainable debt 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., non-US dollar bonds) would be a good hedge against a falling dollar. These bonds offer higher interest rates than the US dollar, and their local currencies would appreciate against the dollar, allowing for capital appreciation as well.

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

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