Global Inflation: What’s an Investor to do?

It is well known that the response of Global Central Bankers to the financial meltdown in the of Fall 2008 was to flood the financial markets with enormous liquidity and cut interest rates to near zero.

The response of financial markets has been a recovery in traded securities values.

However, as this particular economic contraction is at its core one driven by over-leverage by US, and to a lesser extent UK, households according to Economist Magazine, it could take a long time for a recovery to take hold and produce private sector jobs.

Even with the best of fiscal policy, the road back could be a long one. However, the fiscal policy response in the US has hardly been responsible. Rather than reducing tax burdens to spur economic growth, the response has been to add on governmental spending largely from the US federal government to protected unionised worker groups in the state and local governmental sectors, and to dole out construction contracts to higher cost unionized contracts.

It’s been estimated by an number of economists that the multipler effect of government spending is not the 1.5X the Obama administration claims, but more like .75, which means government spending decreases the net wealth in the society. Combined with the conversion of$1.6 Trillion in Fannie and Freddie debt, the reality is that US federal government debt will move to $16 Trililon over the upcoming decade.

It’s been well documented in the US that the state and local government situation is also dire, driven by generous union pension obligations for state and local government workers. The administration is pursuing a political strategy to increase the size of the US government and the persons dependent on its largesse, in an echo of the democrat parties role model, Franklin Roosevelt and it modern day incarnation, the Western European formulation of social democracy.

This model favours a heavy governmental role to level inequality and increase the safety net from consequences of economic change, but with it comes a severe reduction in the incentive to create economic wealth and invention among small and new enterprises.

What this all means is that the political forces that support inflation are growing very much stronger. In the Eurozone, the southern tier governments have made too many promises relative to their resources (Greece merely being the most blatant, Spain and Italy not far behind) and in the US, the spending levels contemplated are so high that either taxes must be dramatically increased over time, or these obligations must be devalued through a debasement of the currency, in short, inflation.

Raising taxes in the US is very difficult, so it is likely that governmental revenues of obligations will have to be adjusted using other methods. While the US Federal Reserve will attempt to provide the veneer of stability, it’s actual strategy is more likely to smooth the rough edges to a higher level of inflation, as long as the fiscal policy of the US does not change to one more focused on private sector job formation.

However, markets in general are slow to recognize a change, but once they do they act swiftly…..the Greek/Spainish/ Euro drama that is currently unfolding being but the latest example.

The constituency for stable currency is found amongst the Germans, and other creditor nations. However, unless there is a re-birth of the Deutsche Mark, there are few currencies large enough to be a viable international store of value.

If one believes that inflation in indeed coming at some point in the next several years in the major currency zones, how can investors protect their assets? The first option is to purchase explicitly inflation protected securities, such as the US Treasury TIPS, in which the principal adjust with US CPI. These assets yield about 2 per cent on a real basis for a 20 year bond (a 30-year TIPS was just issued last week).

The second approach is to take on more risk by investing in assets (“hard assets”) that usually increase in value when currencies depreciate—such as commodities, Oil funds, gold, and real estate. However, if you want more yield that TIPS, and less risk than hard assets, your options are not that many.

You could purchase a “short duration” bond funds so that your principal risk is minimized and your yield re-sets with expected increases in interest rates. The lack of many alternatives is exposing a market need and driving financial innovation to solve the need. More on how that need is being met in upcoming columns.

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