And the Winner Is? Inflation by TKO

By wmadministrator

In politics, you often see two candidates on the absolute opposite sides of a basic issue. But, it is somewhat rare to hear so many financial analysts and economists vehemently disagree over the basic issue as to whether we are in headed into an “inflationary” or a “deflationary” spiral.

For example, Warren Buffett suggests, “We are certainly doing things that could lead to a lot of inflation. In economics, there is no free lunch.” On the other hand, Nobel prize-winning Princeton economist and New York Times columnist Paul Krugman retorts, “Deflation, not inflation, is the clear and present danger.”
Watching this inflation versus deflation debate play out over the last 12 months has been very interesting. In fact, we still have about 50 percent of economists on either side of the argument. The winner of this inflation-deflation struggle will have a dramatic effect on your portfolios. In a nutshell, if you knew the likely winner, you could position your portfolio to try to stay ahead of the macroeconomic curve for the rest of the year.

As we search for reasons behind the recent rise in the equity markets, we find a major macroeconomic event in the United States that overshadowed both the healthcare bill and sovereign debt issues. On March 13th, there were press reports that President Obama is intending to nominate Janet Yellen as vice chairman of the Fed – the No. 2 spot after Fed Chairman Ben Bernanke. The vice-chair position comes by way of the retiring Fed governor Donald Kohn, who plans to step down in June.

Subsequently, the White House has said the top candidates for the other two remaining board slots are the relatively unknown attorney Sarah Raskin, Maryland’s commissioner on financial regulation, and Peter Diamond, a well-known Social Security specialist from MIT.

The three appointments together suggest a new bloc of votes on the policy-setting Federal Open Market Committee for dovish monetary policies, i.e. those less concerned with containing inflation than reducing unemployment.

Yellen’s influence is likely to be crucial, and it is abundantly clear that she is in no rush to raise interest rates. The key reason is the weak labor market. In a speech on March 23rd, she implied that the “extended period” of low rates could last until 2013. It may be just coincidence that such timing would be just after the next presidential election, but common sense would suggest otherwise.

As the market began to digest Yellen’s approach, the spread on 2-10 Treasury yields began to widen. I believe this is a sign that the market is forecasting that inflation is the now the most likely winner of the great inflation-deflation debate.

As such, your portfolio should be heavily weighted toward an equity market that will rise in absolute terms. In other words, it is hard to bet against the rise in the nominal value of U.S. equity markets as long as Bernanke and his new trio of inflation doves are at the helm of the Fed’s printing press.

I believe Fed Chairman Ben Bernanke has decided that monetizing our debt is the only way to fix the balance sheets of banks, homeowners, and the U.S. government. We are a nation of debtors and, whether we want to acknowledge it or not, we owe the Chinese a lot of U.S. dollars.

Because we are debtors, inflation decreases the real value of our debt. So, by printing more money, or “monetizing our debt,” Mr. Bernanke believes we will eventually fix our balance sheet problem.

It sounds counterintuitive, but consider this example: Your name is Ronald McDonald and you can produce Big Macs and sell them at a cost of $3 (U.S.) in all international markets. You happen to owe your rich Chinese business partner $1,000. In other words, you owe your Chinese business partner either $1,000 or 333 Big Macs. However, if because of a dramatically cheaper dollar the price of Big Macs suddenly rises to $50 because of a dramatically cheaper dollar, you then only owe your Chinese business partner 20 Big Macs instead of the 333.

Through this example, one can see that monetizing our debt, which will cheapen dollars’ value, has the added effect of causing the Chinese and other countries to stop pegging their currency to our dollar at artificially low levels. Monetizing our debt implicitly makes other countries want to hold fewer dollars because these dollars will lose their value quickly.

So what should you do to protect your purchasing power during this expected rise in inflation? Consider investing in multinational companies that produce goods that are in dollar-denominated assets (e.g. gold, oil, steel, coffee and most other commodities). As the world continues to shift away from dollars, the absolute value of these companies should only rise because the underlying price (in dollars) of the goods they produce will increase. In other words, these companies will have bigger and bigger margins as the absolute value of your dollar decreases.

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