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Just as the specter of deflation is gaining ground, Warren Buffett is taking the contrarian view and positioning Berkshire Hathaway's (NYSE: BRK-A ) (NYSE: BRK-B ) bond portfolio for higher inflation. Has he lost the plot?
In the second quarter, Buffett continued to rebalance Berkshire's $34.5 billion fixed-income portfolio toward shorter maturity bonds, which bonds are less sensitive to increasing interest rates. When interest rates go up, which, barring a Japanese "lost decade" scenario, will eventually happen, bond values go down -- but the shorter maturity bonds go down less.
Buffett's inflation warning
Back in August 2009, Buffett wrote an opinion piece in the New York Times warning investors that lawmakers will be tempted to simply let the Fed print away the exploding national debt instead of making hard choices, i.e., some combination of raising taxes and reducing government spending.
In this context, Buffett's actions make perfect sense for two reasons:
- Sure, the immediate risk we face is deflation, but the longer-term risk is, without a doubt, inflation. In that regard, Buffett isn't so much taking a contrarian view as he is taking the long-term view, which is exactly the perspective he has always adopted in his business and investment decision-making.
- Within a system as complex as the national economy, Buffett knows that inflation doesn't pop up on appointment; the timing is completely unpredictable, and it could happen faster than the market currently anticipates.
An effective inflation hedge
While high inflation is bad for bonds, eating away at the purchasing power of the fixed income stream they represent, equities are an effective hedge against rising prices. That is particularly true of the stocks of businesses with a well-protected franchise and pricing power.
Franchise businesses for the win
Happily for Buffett, these are exactly the type of stocks he favors, and Berkshire's portfolio is chock-full of them. Among the best known are Coca-Cola (NYSE: KO ) , American Express (NYSE: AXP ) , and Procter & Gamble (NYSE: PG ) -- all three of which represent core positions that go back several decades.
To top it all off, high-quality stocks such as these are suitable investments whether the environment is deflationary or inflationary. Even if you don't agree with Buffett on the economic outlook, it's tough to argue with his investing approach.
With the recovery stalling and the economy on the brink of deflation, a sustainable dividend will become increasingly valuable. Jordan DiPietro has identified the best dividend stock. Period.
Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. American Express, Berkshire Hathaway, and Coca-Cola are Motley Fool Inside Value selections. Berkshire Hathaway is a Motley Fool Stock Advisor pick. Coca-Cola and Procter & Gamble are Motley Fool Income Investor recommendations. The Fool owns shares of and has Write Covered Calls on Procter & Gamble. The Fool owns shares of Berkshire Hathaway and Coca-Cola. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.