August 2009
If one were to assume that inflation, or hyperinflation, will occur, how would one proceed?
Here's a question, sent to us by a client via e-mail, which we suspect is subliminally on the agenda of most investors. The concern arises, of course, since attempting to weather the recent global financial market storm and narrowly avoiding a full-blown deflationary collapse in housing values (particularly in the U.S. and U.K.), world-wide central banks have lowered short-term interest rates to nearly zero. Credit is becoming available once again, and the banking system has been flooded with liquidity; all of which is intended to encourage banks, businesses and consumers to resume more normal patterns of commerce. At the same time, the changed political landscape in Washington suggests future fiscal deficits of unheard of proportions, and by policy, government involvement in the free markets and our daily lives never before experienced.
For the moment, a pull-back from the deflationary abyss seems to have been engineered, but the expansionary monetary forces set in motion, and the apparent political direction at the Federal government level, raise cautionary markers which should not be ignored as one considers portfolio investment adjustments during the months ahead. In our last quarterly review letter, we discussed our current balanced portfolio strategy. We suggested our approach is an attempt to offset prevailing deflationary tendencies through broadened fixed income diversification, and to compensate for future inflationary tendencies through an initial position in a global real estate investment trust (REIT), plus continued exposure to hard assets through a natural resources fund.
From the Deflationary Brink to ?
However, our client's question at the outset of this letter is not so much focused on the immediate effects of our central bank, the Federal Reserve's recent reflationary policy efforts to turn around investor sentiment, but rather the chances that longer-term expectations shift from mild, "acceptable" (2-3% per year) inflation to something more extreme (e.g., 13% per year of the late 1970s). Federal Reserve Bank Chairman, Ben Bernanke, whose field of study while an academician was the Great Depression of the 1930s, has stated he is well aware of the inflationary implications of the Fed's counter-deflation money supply infusions of the past 18 months. He indicates as well he is prepared to reverse any resulting inflationary tendencies with tactics which will contract the money supply and raise interest rates.
Simultaneously, he has launched a "getting-to-know-me" campaign aimed at improving his reappointment chances when his four-year term ends next January. Although in the eyes of most, he has done a more-than-creditable job during his present term as Chairman, there are a number in Congress who feel he is too independent (read not liberal enough) and who will attempt to block his reappointment. So until the Chairman's reappointment process runs its course, the Fed will be constrained to hold rates at current low levels and remain accommodative in its policy statements. Although this would normally give rise to increasing inflationary expectations, luckily, there is presently enough slack in the U.S. economy (high unemployment, strong labor productivity, abundant factory capacity, etc.) to offset any immediate Consumer Price Index (CPI) pressures. But if trade protectionism, environmental protection (i.e., Cap and Trade) bills as well as health care reform and card check legislation all become a reality, America's fiscal situation will deteriorate further and accelerated levels of inflation might be expected which would provide a difficult environment for equities.
A Point of Inflection
With economists and many chartists today declaring an end to the worst recession since the early 1930s, and the U.S. stock market (the most visible of leading indicators as represented by the S&P 500 Index) 48.2% above its low of March 9th, it would not be surprising if investor attention next turned to the inflationary outlook. Playing on fears of a replay of a late 1970s-like CPI escalation, already gold bullion and coin sales ads are beginning to appear on television. For those old enough to remember, the decade of the 1970s was initially kicked off by OPEC's petroleum embargo which led to a 300% increase in the price of oil. What followed were lines at the gas station, U.S. Treasury Bills paying 19% interest, bank borrowing rates of 22%, gold above the $800/oz. level, and silver at $55/oz. Swiss Franc annuities were all the rage and survivalist-catering-vendors touting freeze-dried foods for those retreating from their urban existence for the country life became prevalent. Jimmy Carter berated us all for a lack of moral fiber and our inability to rise out of the economic malaise for which, in his view, we were all somehow responsible.
It was a depressing period. Toward the end of the decade, the U.S. dollar was losing value daily against hard assets as well as foreign currencies backed by precious metals. In the late 1970s, the spotlight was on gold, and for a period it was the asset class de jour. But, as is usually the case, timing was (is) everything, and as you will note from these two exhibits (PDF) (both beginning at the time when Nixon severed the link between gold and the U.S. dollar) there was only one truly profitable period to own gold. If you bought Eagles or Krugerrands (i.e., one ounce gold coins) in 1976 and sold out prior to 1980, and then reinvested in equities, you would have bettered inflation by a wide margin. However, for the entire time during the past 40 years, the compound annual growth rate of global equities outperformed gold, although both eclipsed the annual inflation rate (CPI 4.5% vs. EAFE 9.3% vs. gold 8.7% vs. S&P 500 9.6%). See "Buy/Hold" row on Stocks/Bonds/Cash/Gold Returns (PDF) on Ned Davis chart for asset class returns since 1968, a slightly longer time period. Silver experienced similar textbook cyclical price gyrations, culminating in the collapse of the Hunt Brothers' trading attempt to corner the market in the late 1970s.
Lessons Learned
In economics, finance and portfolio strategy, of course, history seldom repeats itself, but is often useful as a guide or indicator. With this in mind, our equity portfolio posture in a hypothetical era of hyperinflation would exhibit a greater weighting in hard assets and real estate. In the fixed income segment an increased allocation to U.S. Treasury Inflation Protected Bonds would evolve. But contemplate also that should we find ourselves mired in such uncomfortable inflationary circumstances, the Federal government (i.e., a populist Congress) could well outlaw the private ownership of precious metals for investment or wealth preservation purposes. If that transpired, there would be no place for investors to hide or to preserve the purchasing power of their assets. Further, if it were decreed to be illegal for a private citizen to use gold (i.e., all precious metals) as legal tender, no doubt international currency exchange controls would already be in place. One's Swiss Franc annuity might be blocked for all but Swiss citizens.
The probability of any of this coming to pass has to be assessed at very low odds. It would appear, for example, that cooler heads may prevail in the health care reform debate, and that some of the pending, more costly social engineering legislation may be tabled for further debate. Our portfolio structure will continue to stress a diversified list of asset classes, each weighted according to their relative valuation and anticipated correlation with our ongoing assessment of the evolving inflation outlook.
Please let me know if you have any comments.
Regards,
James L. Joslin
Chairman & CEO