Those of our clients who attended our seminar last month know that it is our belief that 2011 will prove to be a transition year for the markets – a transition between the ongoing recovery from the recession of 2008, and the coming years of inflation. All of the economic news we have seen in the past month has confirmed our view. Growth in the U.S. and Canada continues to be anemic, but there is now very little chance of a “double dip” recession. Corporate profits have been better, in some cases much better, than expected. Growth in Asian economies continue to barrel ahead, providing support for most commodity prices. Stock markets have put in a very solid four months, buoyed by continuing low interest rates.
Our concerns centre on 2012 and beyond. The prospect of inflation on a scale that we have not experienced in North America since the early 1980’s seems very likely to us. This is due to two main factors: the need to boost employment in the U.S. and the imperative to deal with the U.S. debt and deficit problem. The results of the midterm elections are not likely to be positive in either regard. Hard choices and the need to face economic reality in terms of entitlement programs and taxes do not go well with a situation in which the White House and Congress are controlled by warring parties.
The U.S. government is under tremendous pressure to stimulate the economy in order to grow employment. The most likely mechanism will be the so-called “quantitative easing” which will be carried out by the Federal Reserve Bank. In essence, the U.S. treasury will print money and lend it to the Fed, which will use it to buy bonds in the open market. This will increase the price of bonds, thus lowering interest rates, and will increase the amount of money in the economy. The result, in theory, should be easier bank credit for individuals and businesses, leading to more hiring by companies. It will also, in our view, lead to inflation.
The extensive work of the Chicago School of economists, led by the late Milton Friedman, has led many to the view that any expansion of the money supply will increase inflation. This is summed up neatly in Friedman’s famous remark: “Inflation is everywhere and always a monetary phenomenon”. The Fed, of course, knows this but the second imperative, the need to deal with the U.S. debt, makes inflation desirable. For many centuries, countries which have found themselves owing too much money have resorted to inflation to escape the debt trap. Formerly known as currency debasement (gold and silver coins were debased by mixture with lead, copper and tin) the debtor country ends up paying back its creditors in money that is worth less than that which it borrowed. The U.S. is in a great position to do this. As issuer of the world “reserve currency” it can get away with this much longer than any other country.
Higher inflation will result in higher interest rates, likely starting in 2012, and lasting for a significant period thereafter. Inflation boosts the value of things such as energy, metals, real estate and timber, but erodes the value of obligations such as bonds, pensions and annuities. Investors who are currently living in a low interest rate, low inflation world, will need to adapt to a new reality.
While we readily acknowledge that forecasts are subject to change as more facts come to light, we have started the process of insulating your portfolio against higher inflation by utilizing three layers. The first layer involves holding companies that are invested in or produce real assets. Your portfolio will hold a combination of base metal miners, oil sands producers, real estate conglomerates and food providers. For the second layer, you must hold companies with pricing power. Companies that can quickly adjust their prices and pass them on to customers will do well in this environment. Holding essential retailers, shippers, banks and utilities will help to lessen the impact of inflation. Finally, we reduced the maturity of your bond and preferred share portfolio to five years or less and we have purchased a significant amount of inflation protected bonds. Higher inflation will lead to higher interest rates and short bond maturities will ensure you have the cash to ready to reinvest when rates have risen.
