Inflation – A Silent Menace about to Roar?

Economist Milt Friedman said “Inflation is an old, old disease.” As I pine for 35¢ gasoline in my youth, so too will my daughter about $4 to her future great grandkids. A question on many investors’ minds today is “How hard and fast will inflation hit?” Some fear hyperinflation will return.

I’m no economist – and if I was, you could ask me and 11 of my colleagues for a forecast and you’d get 13 answers – yet I’ll share some insights on the impacts of inflation to investors, diverging inflation expectations, and actions you might consider for protection or opportunity. This is general advice – talk with your advisors about your particulars.

Recently I met with a 25 year old couple eager to embark on their 40 year trek of wealth accumulation. We calculated the annual savings and investment returns required to maintain a current $5k per month lifestyle through a 30 plus year retirement. They will need to accumulate about $4.1 million to fund an inflation-adjusted $16k per month at retirement (assumes 3% inflation, 6% returns). That’s a little over 3 times their current monthly spend rate just to keep up (plus future pay raises throughout retirement)! You’d think that erosionary effect should make the headlines. But instead, market crashes, black swans, and Bernie Madoffs take first cabin, and inflation is resigned to “silent menace.”

Inflationary outlooks vary. Critics of QE2 and money supply expansion (and bank reserves) argue they’re fuels for inflation, possibly hyperinflation (remember 20-22% money markets and 14-16% mortgages of the late 70’s early 80’s). Others worry the government will print greenbacks and inflate its way out of debt and deficits (“easier” than to curb spending or hike taxes). The opposing camps (tamer inflation) argue our high unemployment rate is a huge damper, and commodity driven inflation will pass. Oil hit $145 in July ’08, fell to $45 in 6 months, and now stands at $112; gold’s been on a decade long tear to $1,500, but have goldbugs forgotten about an eventual gold supply response? And others argue the banks aren’t lending, and bank reserves are growing – since 2008, the traditional relationship among reserves, lending and inflationary pressure have been broken.

Whatever camp you reside, inflation is the relation between supply and demand for money. Demand will eventually rise as the economy continues to recover, housing stabilizes and borrower confidence resumes.

Inflation-protection investor opportunities include:

• Borrowers payoff/fix adjustable rate debt.

• Own asset classes & sectors – Stocks tend to offer greater protection than bonds (but may lag in high inflationary times), real and hard assets, and commodities. Look to materials and energy sectors. Consider companies that have pricing power.

• Adjust fixed income sectors – Long term bonds, preferred stocks, etc. will likely decline in price. Shorten duration – higher yields and lessen maturities. TIPS, convertibles, foreign debt, and absolute return/flexible (e.g. floating rate funds).

One final thought… we live through cycles. Whether inflation is tame or raging, it’s averaged about 3.1% since 1913. Protect yourself.

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