Your Investment Strategy May Need an Overhaul

Even though the Fed suggests that the economy has bottomed out and is poised to start growing again, the central bank has yet to lay out details of its so-called "exit strategy" to unwind all the steps it has taken in the past year to try and get the economy back on track.

Guys, I'm telling you, we can't go any lower.

The Federal Reserve is studying the idea of borrowing money from the money-market mutual fund industry as part of its exit strategy to avoid post-crisis inflation. Some economists worry that if the Fed is too slow to rein in its various liquidity programs, all the cash it has injected into the financial system could spark a jump in inflation.

"The ingredients for runaway inflation down the road remain in place," said Allen Sinai, chief global economist for Decision Economics. "Right now inflation is quiet, but it's a sneaky problem.” Fed Chairman Ben Bernanke has repeatedly said the central bank has the tools it needs to pull back on these programs, but he has yet to say how or when it will do so.

Let's quickly reflect on why the inflation/deflation outlook is now the hardest investing problem to solve …

Strong Arguments on Either Side

Both sides of the inflation/deflation debate can make a strong case. Firstly, many Western countries have had their second shattering collapse in household wealth in ten years. That has left behind a vast debt burden which consumers are now finally starting to pay down.

We also have a huge amount of spare capacity in the economy caused by the collapse in demand. This means that less money available for investment (because people have less disposable income to spare) caused prices to come down. That includes the labor market, where U.S. unemployment is closing in on its post-war high. These are ingredients for deflation.

But on the other hand, we have central banks determined to forestall that, both through increasing the supply of money and lowering its cost (interest rates that are a record low and likely to stay that way for a while). Loose monetary conditions like this are naturally inflationary. This is because the more money people have and the cheaper the money is to get, the more people will spend. This causes inflation.

Both sides can make a convincing argument on why they will win out. Deflationists point to the experience of Japan after the bubble burst in 1989, where, despite the central bank's attempts at quantitative easing, debt-induced deflation still reigned. Inflationists say this only proves that Japan was too half-hearted. They claim that other less well-known examples of quantitative easing, such as Japan in the 1930s and the US in 1949, quickly brought about double-digit inflation.

A Recipe for Stagnation

It is likely that for the next few years, we will end up with something in between. For now we have deflation across most of the world. Ultimately, we believe that high inflation is a possibility. Western governments have no option but to generate inflation (and thus higher nominal GDP growth) in an effort to cut their crippling debt/GDP ratios. But if the point when central banks finally gain traction is ten years away or so, returns from a hyperinflation bet in the meantime are likely to be disappointing.

Maybe just bet half.

In short, we're in a middle ground that doesn't favor big one-way bets. This is a selective market, where you get the best returns by making the best choices within each asset class — be it equities, bonds, property or whatever.

Investment Strategies

We can't be absolutely sure what the outcome will be. The global economy is at a major turning point and anyone who claims they know for certain whether inflation or deflation will win out is dangerously overconfident. We prefer to construct our portfolios in a way that gives us plenty of upside if we're right and limits the downside if we're wrong.

If you are putting all your money in cash to avoid risk and inflation is the outcome, you will lose significant buying power with that cash. In other words, if everything increases in cost by 7% (inflation) and your money in the bank grew by 2%, you would lose 5% of the buying power of your cash.

Stocks?

When it comes to stocks, taking either a very optimistic (bullish) or negative (bearish) view when constructing a portfolio that rides the economic wave to success is very risky and could be devastating!

Equities are a real asset, since earnings and dividends generally rise in line with inflation over the long run. While they would perform poorly during a seventies-style high-inflation scenario because costs increases can't be passed on instantly, you'd expect them to recover in the long run. Deflation is more dangerous because of the risk that highly leveraged companies will not survive. Companies that have sustainable competitive advantages and thus pricing power during inflationary times should fare well.

When inflation is higher, small-cap stocks benefit as well. Smaller companies do better during times of negative real interest rates, i.e. times—like now—when interest rates are lower than the inflation rate.

Bonds?

Bonds are a nominal asset and usually have a fixed term until repayment. Higher inflation permanently erodes their returns. Bonds are attractive now in an environment of low deflation or low inflation. But as we expect inflation to pick up five to ten years down the line, we will favor bonds or bond funds with lower duration.

No, not him

When inflation is low, banks offer very low rates of return and bonds offer higher returns to account for the higher risk of bonds over bank accounts. As inflation and bank account returns rise, the return on bonds increases. This is done to provide investors more return for their increased risk. If you purchased a low risk bond that was paying a 6% dividend before an increase in inflation, a bond of similar risk purchased after an increase in inflation of 3%, might pay 9%.

Obviously, your 6% would decrease in value considerably when investors could buy a bond of the same risk as your could get a higher return. To combat some of this risk, a simple bond option is the Treasury Inflation-Protected Security (TIPS). IPS keep up with rising inflation since the yield is indexed to the consumer price index. Yields on TIPS are currently at 4%.

Alternative Investments are the Key

Gold, oil, natural gas — all purchased through the use of individual stocks and/or exchange-traded funds – could be a welcomed addition to your portfolio in the face of uncertain inflation or deflation. Foreign currencies (etfs and structured notes) are also an option for the bearish dollar trade.

These investment options are not directly tied to US economy and the rise or fall of the value of the dollar. Many of our clients have been exploring and investing in these investment classes as a hedge against inflation and movement of the dollar.

Other popular investment strategies include programs that are not traded on a public exchange like the New York Stock Exchange. Non-traded real estate investment trusts, leasing funds, and oil and gas drilling programs are a few examples. Given recent market conditions, many physician investors have been attracted to non-traded programs because they offer a certain level of stability. Also consider diversifying your portfolio by building or participating in surgery centers or other profitable health care investments.

Analysis

Inflation is likely to punish anyone—and any company—that's not in good financial shape. One of the biggest problems that inflation causes is uncertainty. Commodity markets are currently priced assuming future "hyperinflation," while the prices on bond markets predict little or no inflation. One of them has to give, but we’ll only know that in our rearview mirror. Inflation deals a wild card, making it much harder to anticipate the direction of the economy and the markets.

Christopher Jarvis is a principal of the financial consulting firm of O’Dell Jarvis Mandell LLC, where Kim Renners is the Director of Wealth Management.This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the financial markets involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. For additional information about the OJM Group, including fees and services, send for our disclosure statement as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.