Portfolio Strategy Review Q1 2015

by | Apr 16, 2015 | Portfolio Strategy

Inflation, Deflation, and the Value of Your Assets

Current market speculation is that the Federal Reserve will raise rates to keep the inflation genie in the bottle.  Or not. Deflationary forces such as a strong dollar, weak commodity prices, and stagnant wage growth are prevalent. Some economists contend that undetected inflationary pressures are building; others say we are in the midst of a debt-ridden, demographic-driven, and technology-enabled deflationary spiral. What risk do these contrasting forces pose for the value of your assets?

Government monetary and fiscal policies are designed to create economic incentives to borrow, invest, or consume. Fiscal policy has been missing in action due to political posturing, while monetary policy has been guided by a fear of deflation. Monetary stimulus (low interest rates and quantitative easing) encourages indebtedness, consumption, and drives capital toward assets with more risk and return potential. This trend has been in place since 2009, giving rise to strong gains in the stock market and real estate. Normally, this cycle brings inflation and higher interest rates.

Inflation occurs when there is an oversupply of money which drives the price of goods and services higher. If these prices grow faster than your income and assets, your purchasing power and living standards will decrease. Since World War II, inflation has been the biggest risk for financial assets over short time periods. Over longer time horizons stocks, real estate, and commodities are assets that, historically, helped money to grow faster than inflation because they adjust for the supply and demand of goods and services.

Deflation occurs when business and consumers delay investment and purchase decisions. Rates remain low to try and stimulate demand for money. Once price deflation sets in, it is very hard for government policies to induce change. Hard asset can lose value; cash and bonds become more valuable as prices decline. If consumers anticipate further price declines, they will delay purchases and thereby further weaken the economic environment.

Inflation or deflation in the US? With rates at multi-decade lows, there isn’t much more central bankers can do to stimulate economic activity.  Long term market rates are determined by the supply and demand for money, yet even as the stock markets and the economy have recovered rates have declined. It’s not what you expect in an economic recovery. Monetary policies have distorted market mechanisms.

Asset Risk and Return during Inflation and Deflation

Financial assets are directly linked to economic activity. Stock prices are driven by the expected growth in corporate profits; bonds by inflation expectations. Stocks and dividends ultimately adjust for inflation. Bonds are “fixed” price instruments. They can’t adjust to rising inflation and interest rates and they lose value. However, during deflationary periods when rates fall this fixed asset is safer to hold. Japan has fought deflation for over two decades; consequently, its bond market has outperformed its stock market since 1989. Europe may also be on the edge of a deflationary situation.

A quick history lesson: In the 17th-19th centuries, deflation was the biggest risk to US financial assets.  Stocks outperformed bonds by less than 1.0%, according to Global Financial Data. In the 20th century, inflation was a larger risk for asset prices (except for the Depression era).  Stocks outperformed bonds by 5.5%.  A 19th century investor would not have expected this kind of “risk premium” for owning stocks. The point is that market environments for assets can change depending on government policies, interest rates, and inflation.

 That Was Then, What about Now?

Let’s make the point more relevant. The table below looks at 10 year cycles and how the direction of rates and inflation impact both stock and bond performance. With rates rising from the 1940’s-1970’s, bond returns were negative after adjusting for inflation; whereas declining rates since the 1980’s have resulted in strong bond performance.  From 1930-2014, the “risk premium”, or how much more return investors require for stock than bonds, averaged about 5% with a range of -8.4% to 20.7%. This data shows us how and why risk sentiment rises and falls; unfortunately, it doesn’t tell us when.

How to Plan For the Unpredictable?

Interest rates are currently near multi-decade lows. Inflation is well below historic levels. What will the next year look like? The next 10 years? Tune in to CNBC for an hour and your head will spin listening to prognosticators pretend that their crystal ball has 20-20 foresight. Timing the shifts in risk appetite could be very profitable – if and only if – it could be done consistently. Market studies clearly show that the odds in trying to predict short-term outcomes in financial markets is a losing game.

How best to balance risk against return?  The table below presents a reasonable view of how you might expect assets to behave during bouts of deflation and inflation.

The table also makes the case for why a diversified strategic mix of assets can help reduce risk during different economic and market conditions. In addition, our rebalancing discipline and cost containment keep risk and return levels in your comfort zone, while enabling more of your money to work for you.  

PLEASE NOTE: You can’t invest directly in an index. Past performance does not guarantee future performance. All investments are subject to risk, including possible loss of the money you invest. Diversification does not guarantee profit or protect against a loss. Nothing herein or elsewhere on this site constitutes investment, legal, or tax advice. For details please see Disclosure.

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