Inflation might decimate your wealth

In February this year, we wrote that the sovereign debt crisis, pervasive in the developed world, was “certain to lead at some point to a prolonged period of inflation.” We are now in the early stages of that period and an acceleration of inflation is now virtually certain. Unless investors move aggressively to protect their wealth, they are likely to lose 50% or more of their wealth’s purchasing power in the coming years.

Why high inflation is now inevitable
Through history, runaway inflation episodes ensued when governments spent far in excess of their tax revenues. The pattern of events leading to out-of-control inflations begins with the breakdown of fiscal discipline and ballooning government spending, usually in pursuit of economic recovery or wars (or both). Fiscal discipline breaks down because deficit spending by governments at first appear beneficial and politically advantageous. In The Dying of Money, Jens O. Parssons writes:

“Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle.”

To varying degrees, governments of all developed nations have succumbed to temptations of prosperity and prestige that can be bought by overspending and by now, years of binging on easy credit generated an unpayable mountain of debts:

Table: debt load by country

The situation is not as bad as these figures suggest: it is much worse. Deficit spending is continuing at a rate ranging between 3% (Germany) and 14% (Ireland) of the GDP. Worse yet, we can safely assume that official government figures don’t tell the whole story. Take the United States: its official debt is “only” 96% of the GDP. But add the unfunded liabilities and we are looking at a debt load of over $100 trillion. Boston University professor Laurance Kotlikoff estimates the figure at $200 trillion or 840% of the current GDP. Similarly, while the official deficit spending is running at about 9% of the GDP, the figure would be closer to 30% of the GDP ($4 to $5 trillion) if it was calculated according to the Generally Accepted Accounting Principles (GAAP). Even the US’s GDP figure is now suspect as much of it reflects a virtual economy of financial transaction that generate no real wealth. It is highly probable that governments of most of the other developed nations are engaging in similar book cooking.

Austerity won’t cover the fiscal gap
To cover the fiscal gap and start paying down the debts, governments would have to increase taxes and drastically reduce spending. According to the IMF, closing the US fiscal gap would require an immediate and permanent doubling of all US federal taxes. Such severe austerity is a political issue, which pretty much determines the outcome: the political classes of sovereign nations always prefer profligate spending to fiscal discipline under the scientific/ideological cover of Keynesian economics.

For one thing, austerity would further reduce economic activity and the government’s tax revenues with it. Soaring interest rates would worsen the already unsustainable debt burden. In addition, austerity might lead to social upheaval and push large segments of the economy onto black markets. In short, austerity is tedious and depressing. By contrast, spending money is so much more fun. Politicians and economists paid to tell them what they want to hear get to talk about the virtuous cycle where economic growth will generate a trade surplus and help bridge the fiscal gap, with prosperity and full employment and happy days for all. Not to be overlooked, deficit spending might buy politicians more terms in office. This consideration alone makes nearly any risk worth taking.

Just in the last few days, we saw this principle at work twice. First, US Congressman Ron Paul stated that the US Deficit Reduction Commission rejected his calls to reduce military spending. The Commission did not want to make any cuts “during the recession,” because that “would weaken the economy.” A few days later we also learned that President Obama’s administration will both extend Unemployment Insurance for 13 months and extend Bush tax cuts for another two years. So much for fiscal discipline.

Stimulus spending won’t reignite economic growth
But just for the sake of argument: could deficit spending stimulate developed economies back to full employment and trade surplus? In short, no. Marginal productivity of debt in the developed economies has been steadily declining over the last forty years. In the US economy, it has now turned negative, as the following chart shows.

According to the U.S. Treasury March 11, 2010 Flow of Funds report, marginal productivity of debt in the US economy has turned negative. Source: http://www.economicedge.blogspot.com

While in the 1970s each Dollar of new debt generated around $0.60 in GDP, today each Dollar of new debt generates negative GDP growth. The results of two years of unprecedented stimulus spending and quantitative easing pretty much confirm this (see here for the latest on that).

Money printing is now the preferred option
As hopes of salvation through economic growth fizzle out and sovereign governments are unwilling or unable to effect sufficiently stringent austerity measures, they have no recourse but to debase their currencies through inflation, the one form of taxation – as Milton Friedman put it – that can be imposed without legislation.

What happens next?
Gradual, controlled inflation is a normal part of the modern monetary systems, and we are used to currency losing 2% – 3% of its purchasing power each year. Things get problematic when central banks start monetizing government debt to sustain runaway spending. Of course, central bankers and politicians will give us every reassurance: no, they aren’t really printing money, they are sterilizing new emissions; the process is only temporary and fully under control; recovery is just around the corner, and so forth. Fed Chairman Ben Bernanke went on TV last week to reassure us that he’s “100% confident” that he can handle the crisis and keep inflation under control. This is the same person who missed all the warning signs of the 2008 financial crisis and then tragically mismanaged its aftermath.

In the mean while, Mr. Bernanke has piled so much US government debt onto the Fed’s balance sheet, that on 22nd November 2010 it has become the largest holder of government IOUs. History shows that once central banks start monetizing government debt, it is very hard to reverse course and the process is liable to lead to hyperinflation. In fact…

Inflation is already accelerating
The official data – no surprises there – is showing the inflation as benign . The facts on the ground are starkly different. One relevant proxy for inflation is the Commodity Research Bureau (CRB) Spot Index. It is driven by fundamental demand and includes things like copper scrap, lead scrap, steel scrap, tin, zinc, burlap, cotton, print cloth, wool tops, hides, hogs, lard, steers, tallow, butter, soybean oil, lard, print cloth, rosin, and rubber. It also contains no precious metals or energy inputs, so is not driven by higher prices of gold, silver or oil. The CRB Spot Index chart clearly shows an accelerating rise in commodity prices since the beginning of 2009 through mid-December 2010 (at the time of this posting).

CRB Spot Index clearly indicates an acceleration in price inflation

Much anecdotal evidence confirms that inflation is on the rise. Consider a recent report in Forbes describing how JPMorgan Chase dispatches a researcher to several supermarkets in Virginia to comparison shop for a basket of 31 items. JPMorgan found that Wal-Mart increased prices by 5.8% in June alone. We’ve also seen some amusing examples of how Wal-Mart gimmicks its “low price leader” image and hides the effects of inflation.

Inflation will decimate investor wealth
There is no way to reliably forecast future levels of inflation, but estimates based on the M1 money expansion indicate that future inflation might be three times as high as it was in the 1970s! That’s close to 50%, a level that would decimate people’s savings and investors’ wealth. According to historical research by the National Bureau of Economic Research, over two-thirds of the world’s market economies suffered episodes of inflation since 1960 which exceeded 25% in at least one year. On average, investors lost 53% of purchasing power during such episodes. Lee Robinson of Trafalgar Asset Managers estimates that investors are likely to lose between 30% and 60% of their wealth and will not recover for generations. Similar estimate (30% – 50%) was put forward by John Embry, chief investment strategist for Sprott Asset Management.

Some ideas on how to hedge against inflation?
High inflation signifies that money is losing value against real stuff like energy, metals or agricultural commodities utilized by people and firms in conducting their daily activities. These include heating oil, gasoline, copper, aluminum, corn, soybeans, coffee and cotton.

Your best bet: more aggressive CTA mandates
It follows that the best way of protecting your wealth from inflation is by gaining significant exposure to prices of these commodities. The most effective way of doing so is through commodity trading advisors, or CTAs who specialize in investing in commodity futures markets. Investors should strongly consider a fairly aggressive allocation to one or more CTAs with a proven track record and reliable performance.

Investors who allocate to CTAs normally do so with a small portion of their portfolio typically 2% to 5%. They also frequently specify that the highest acceptable draw-down on such allocations is 5% to 10%. Such low allocations with non-aggressive mandates will hardly suffice to offset a 50% or bigger draw-down (in real terms) that inflation might inflict on your entire investment portfolio. To have a truly effective inflation hedge, investors must consider a more aggressive allocation and be prepared to stomach some stout volatility. In selecting their CTAs, they will do well to differentiate between those who, in their attempts to keep volatility low are becoming increasingly correlated with the traditional investment markets, and those that keep appropriate exposure to the commodities markets even in times of higher volatility. For the purposes of obtaining an effective inflation hedge, this is a very important criterion in selection of funds and/or managers. IGS Alternative Investment Solutions provide a good analysis of this subject in a recent article titled, “True CTAs: the promise of portfolio protection, delivered.” For qualified investors, a customized solution should be possible to arrange through individual managed account mandates.

Popular but less effective hedges: gold and equities
The commodity that almost inevitably comes up an inflation hedge is gold. We’d like to share a word of caution here. While it is widely expected that the price of gold will continue appreciating against paper currencies, gold isn’t always the most brilliant investment. The most authoritative study of the behavior of Gold prices through periods of inflation and deflation (going back to 1560) was conducted by UC Berkley’s Roy Jastram. He offers the following conclusions:

– Gold is a poor hedge against major inflations
– Gold appreciates in operational wealth in major deflations
– Gold is an ineffective hedge against yearly commodity price increases
– Gold does maintain its purchasing power over long periods of time. This is not because gold moves toward commodity prices but because commodity prices eventually return to historical levels vs. gold.

Effectiveness of gold as inflation hedge will depend on when and at what price you bought and when and at what price you sell. Consider that, had you bought gold at its peak in January 1980, you would see the value of your investment fall by 70% in nominal terms through 2001. In real terms, your loss was even greater and you’d have to wait until 2008 – full 28 years – to recover the nominal value of your investment.

On the assumption that they are preferable to cash, many consider equities as a good hedge against inflation. The 2008 episode with Zimbabwean inflation and the performance of the country’s stock-market reinforced this view. However, historically, stock markets have not performed so well during inflationary times. In years when inflation rose above 6%, returns on stocks averaged 2.6%. In The Gathering Storm, Dylan Grice makes the following observation: “Some argue that equities hedge against inflation because they are a claim on real assets, but most of the great bear market troughs of the 20th century occurred during inflationary periods.”

A recent McKinsey & Co. article presents an analysis of how inflation destroys firms’ shareholder value by increasing the cost of capital and constricting free cash flow. For example, a jump of inflation to 15% can erode shareholder value by over 60% – even when the firm’s earnings growth keeps pace with inflation.

Not so popular, exotic inflation hedges
Various more or less exotic instruments are available as inflation hedges, including inflation-linked bonds, sovereign CDSs, inflation caps, long-dated swaptions and others that I hesitate to spell out. I have no useful advice to offer on such instruments other than to point out that in virtually all cases with such instruments, investors will be taking on counterparty risk, so tread with caution. And if your counterparty is a government who sells inflation-linked bonds, keep in mind that they will be the ones calculating (cooking) the official inflation figures. Just look at the gimmicking track record of the US Bureau of Labor Statistics.

The bright side: crisis = opportunity

Chinese word for crisis: danger + opportunity

All of the above could make for truly dismal news, but it need not be so. The Chinese word for “crisis” is composed (allegedly) of two characters: the first one denotes danger, the second one opportunity. Whether this is true or not, I certainly believe that the current crisis holds one of our lifetimes’ greatest investing opportunities. The right kind of investment choices will yield enormous returns. Finally, the best possible piece of advice I could offer anyone is this: prepare! The internet is full of valuable research materials, of which I would wholeheartedly suggest the following resources.

 

Resources:
In addition to sources cited in the above text, I highly recommend the following books and articles:

Books:
– “The Gathering Storm” by Lee Robinson and Patrick Young – a must read book!!!
– “Dying of Money” by Jens O. Parsson (the book may be out of print, but the full text is available online)
– “Understanding the Great Depression and the Modern Business Cycles” by Dan Blatt
– “The Golden Constant: English and American Experience” by Roy Jastram
– “Tragedy & Hope: A History of the World in Our Time” by Carroll Quigley – a long book, but largely worth the read, provides a very broad historical context for understanding of current economic and political circumstances.

Articles:
– “Understanding Inflation” by Dan Blatt- perhaps the best article on inflation I’ve come across.
– “Crisis of Inflation on the Horizon? Money Supply Growth Reminiscent of the 1970’s” by the Hennessee Group
– “A quick tour of hyperinflation and the possible consequences for America” by John Silveira
– “Hyperinflation parallels: Weimar Germany vs US/UK” by Dylan Grice
– “Hyperinflation 101” by Mark van der Sluys
– “Hyperinflation will begin in China and will destroy the Dollar” by Eric de Carbonnel

Film:
– The Secret of Oz by Bill Still – this is an absolute must see documentary; it is critical to proper understanding of the monetary system prevalent in the world today.

Good sailing!!!

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