Monday, 17 September 2012

"Inflation is always and everywhere a monetary phenomenon." - Milton Friedman

Last week Ben Bernanke announced another round of quantitative easing (QE3).  This time around the FED's have planned to buy $40Billion of MBS per month.  That's another $480B per year.  Three rounds of massive stimulus have led many people to become concerned about inflation.  

As quoted by Milton Friedman “Inflation is always and everywhere a monetary phenomenon.”  Just ask Zimbabweans who have stopped publishing their inflation rates; last recorded rate was on 2008 Mid-Nov. of 89,700,000,000,000,000,000,000%.

What is inflation?

Simply put, inflation is a decline in ones purchasing power.  As more money is made readily available to consumers (money supply) and is circulated in the system (velocity) the prices of goods and services start to increase making it costlier for you and me. 

Lets take a look at how much money is currently in the system...

It doesn't get any clearer than this!  The massive spike represents billions of dollars freshly printed off the printing press starting sometime around 2008. 

Where is all this money hiding?
Banks have tremendously expanded their balance sheets in the recent years.  Taking a closer look at money in circulation we can see that banks have been hesitant to loan mortgages and consumers unwilling to apply for loans.  Even with ultra low interest rates, people are not taking on debt.

What does this all mean?

The spark!  So much fuel has been pumped into the system in the form of money that a spark to the economy will ignite the fire and then..... an explosion.  Once the economy gets heated and starts to pick up there will be big surprises in inflation rates.  Key numbers to be aware of are employment, consumer lending and housing starts.  These numbers will be a good indicator of the spark.   The Federal Reserve expects the economy to pick up by 2015. 

Portfolio Hedging Strategies

Protecting your investments is important! From a portfolio standpoint if you were holding a 60/40 equity bond portfolio throughout the highest inflation peaks of WWI, WWII and the 1970’s you would have a negative 10 year return real return on your portfolio.  

How can you deliver equity like returns in times of inflation?
Benjamen Graham the father of financial analysis has stated two plays.

     1. Inflation Protected Bonds   
          2. Real Assets (Gold, Commodity Futures, Natural Resource Stocks, REITS)

Taking a closer look at these assets.  I have provided their sensitivity (Beta) to inflation surprises        
Data - (1970-2011)
Commodity Futures
Natural Resource Stocks
Inflation protected bonds
Real Estate Investment Trusts

*inflation surprise is the difference between actual and real inflation

Bottom Line:  Protect your wealth! and be ahead of the curve.  A RAPID rise in inflation will surprise many investors.  Consider holding Gold, Commodity Futures, Natural Resource Stocks and Inflation Protected Bonds as these assets have preformed very well in inflationary periods.  

Spot Gold on Feds announcement

Herman Venegas

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