How We Invest In Inflation

Painting is by my father, Naum Katsenelson

Thoughtfully and humbly. 

We need to recognize that inflation in the long term is a probability but not a certainty. Macroeconomics is a voodoo science; it appropriately belongs in the liberal arts department. The economy is an incredibly complex and unpredictable system. 

Here is an example: Japan is the most indebted developed nation in the world (its debt-to-GDP exceeds 260%, while ours is 130% or so). Its population is shrinking, and thus its level of indebtedness per capita is going up at a much faster rate than the absolute level of debt. Anyone, including yours truly, would have thought that this forest full of dry wood was one lightning strike away from a disastrous conflagration. And yet Japanese interest rates are lower than ours and the country has been mired in a deflationary environment for decades. 

Admittedly, Japan has a lot of unique economic and cultural issues: Companies are primarily run for the benefit of employees, not shareholders (unproductive employees are never let go); there are a lot of zombie companies that should have been allowed to fail decades ago, and the Japanese asset bubble burst in 1991 when debt-to-GDP was only 60%. The point still stands: Long-term forecasting of inflation and deflation is an incredibly difficult and humbling exercise. 

As investors, we have to think not in binary terms but in probabilities. The acceleration of our debt issuance and our government’s seeming indifference to it and to ballooning budget deficits raise the probability and the likely severity of inflation. At the same time, we have to accept the possibility that the economic gods are playing cruel games with us gullible humans and have deflation in store for us instead. 

Inflation and higher interest rates are joined at the hip. The expectation of higher inflation will raise interest rates, as bond investors will demand a higher return. This in turn will result in larger budget deficits and more money printing and thus more borrowing and even higher interest rates.

Here is how we are positioning our portfolio for the risk – the possibility, not the certainty – of long-term inflation: 

Valuation matters more than ever. Higher interest rates are an inconvenience to short-duration assets whose cash flows are near the present and devastating to long-duration assets. Here is a very simple example: When interest rates rise 1%, a bond with a maturity of 3 years will decline about 2.5%, while one with a maturity of 30 years will decline 25% or so. 

The same applies to companies whose cash flows lie far in the future and who are thus very sensitive to increases in the discount rate (interest rates and inflation). Until recently they have disproportionally benefited from low-interest rates.  They are the ones that you will most likely find trading in the bubble territory today. But their high valuations (high price-to-earnings ratio) will revert downward. Value stocks will be back in vogue again. We have started seeing the rotation from growth to value recently. 

1 2 3 4 5
View single page >> |
How did you like this article? Let us know so we can better customize your reading experience.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.