These days, it's popular to be scared of inflation. And rightly so. But if you're to stay ahead of a falling dollar, it's essential to distinguish inflation myth from reality.
Forget what you know -- partially
Below, I've summarized three myth-busting insights recently penned by John Hussman, economist and market-beating fund manager. Spoiler alert: Stocks may not live up to their reputation as championship inflation fighters.
Myth No. 1: Expanded monetary base = inflation
With the Fed having run the printing presses 24/7 since the financial crisis hit, the dollar by definition must be poised to shed value, no?
Not necessarily. Hussman shows that changes in the monetary base and inflation do not always move in lockstep. Look at the 1950s. Or, better yet, take present-day circumstances, where inflation is running at an annual 2.7% (hardly nefarious), even as the monetary base roughly doubled in recent years. Gold bugs, what say you?
Depending on macro conditions, one of several possible scenarios could explain the correlation gap. Today, we might do well to note the difference between the monetary base, which the Fed controls in the form of bank reserves, and the actual money supply in the real economy, which is primarily determined by discretionary bank lending.
A more consistent inflationary trigger, offers Hussman, is government spending.
Allowing for a time lag, changes in government outlays and inflation have historically shown remarkable correlation. Saying hmmm yet?
Hussman explains that as the government aggressively spends, it creates a "relative scarcity of goods and services outside of government control," driving up private-sector costs. Concurrently, the supply of Treasuries rises in order to finance the spending spree, in turn sparking debt-driven concerns and pressuring the dollar.
The result? Inflation. But not because of the usual suspects. As Hussman quips, "the primary determinant of inflation is not monetary policy but fiscal policy."
Ultimately, while the dollar might strengthen relative to even weaker currencies, the current level of U.S. borrowing indicates that the greenback may nonetheless depreciate relative to other stores of value, namely, hard assets. Hence, investors who have been pouring money into SPDR Gold Shares
Myth No. 2: High unemployment and low wages = deflation
This notion is quickly undone. Basically, some argue that generally lower prices will persist so long as we have high unemployment and excess manufacturing capacity. Now, it's true that the latter situation describes low private-sector demand, but Hussman has already shown that the private sector isn't the only variable in the inflation equation.
In fact, based on historical data, elevated unemployment is more strongly correlated with higher rather than lower inflation. Insofar as the government has traditionally attempted to combat unemployment with spending programs, that relationship should sound familiar.
Myth No. 3: Stocks = effective inflation hedge
While it may be true that equity returns run ahead of inflation in the very long term, stocks won't always provide immediate shelter from inflationary spikes. Just take a look at the table below.
|
Year |
12-Month
|
S&P 500 |
|---|---|---|
|
1972 |
3.2% |
19.0% |
|
1973 |
6.2% |
(14.7%) |
|
1974 |
11.0% |
(26.5%) |
|
1975 |
9.1% |
37.2% |
|
1976 |
5.8% |
23.8% |
|
1977 |
6.5% |
(7.2%) |
|
1978 |
7.6% |
6.6% |
|
1979 |
11.3% |
18.4% |
|
1980 |
13.5% |
32.4% |
|
1981 |
10.3% |
(4.9%) |
|
1982 |
6.2% |
21.4% |
Data from Bureau of Labor Statistics and Standard & Poor's.
Citing pendulum swings in sentiment, Hussman explains, "Investors tend to systematically elevate P/E ratios when inflation rates are low and depress P/E ratios when inflation rates are high."
Importantly, investors who bail on stocks as inflation jumps aren't as capricious as you might think. In reality, companies often can't increase prices on par with accelerating costs. For just two examples, look to the most recent stretch of escalating commodity costs, where price increases taken by consumer-goods companies General Mills and Kimberly-Clark
Consequently, stocks aren't always an effective inflation hedge.
So what's the strategy?
Beating inflation year in, year out isn't easy. Pursuing multiple strategies, however, should help. Refusing to pay up for stocks when they're expensive is a good starting point. Also, a healthy dose of Treasury Inflation-Protected Securities (TIPS) could help power your portfolio ahead of a falling dollar. Globally geared companies such as Philip Morris International
As for gold, the yellow metal is probably best classified as an excellent speculation rather than a sound investment. But if you are going to go for the gold, knowing that events such as monetary base expansion don't necessarily presage inflation, may help you avoid investing at sentiment-driven tops.
Personally, I prefer oil, which has both consistently rallied in response to inflation and is more easily valued. Although there's certainly company-based risk, high-quality E&P names such as Petroleo Brasileiro
Finally, simply distinguishing inflation myth from reality will help prevent you from reacting in step with the masses. And that alone should improve your profits -- both nominal and real.
