Preparing Your Investments for an Inflationary Future

Let the boxing match begin!…In the near corner, we find deflation, with its furious fists of debt liquidation and credit contraction… And in the far corner, we’ve got Ben Bernanke’s printing press, with its menacing inflationary uppercut.

Inflation will win this contest eventually, but the match might go the full 12 rounds.

Deflation is no slouch. He packs a mean punch. Borrowers of all types – from single-family mortgage-holders to national governments – are defaulting on their loans…or moving rapidly in that direction. As the weakest of these borrowers fails, asset prices fall and confidence wanes, both of which produce additional defaults. Once this vicious cycle gains fury, all but the strongest – or least leveraged – borrowers endure.

If Greece defaults, for example, Ireland might follow…and so might Portugal and Spain, etc. If Greece defaults, a contagion becomes quite likely, as the folks who are kicking in their tax dollars to the European Central Bank and the IMF begin to realize that their bailouts are futile. Eventually, the taxpayers from relatively solvent nations resist pouring their capital down Greek, Irish or Portuguese rat holes. Eventually, the bailouts end and the defaults – politely known as “restructurings” – begin.

Aware of this grim prospect and fearful of deflationary forces in general, the Central Banks of America and Europe have been counterpunching with various combinations of money-printing, subsidized lending and debt-financed bailouts. In other words, all the classic inflationary responses, plus a few innovations like quantitative easing.

The match between deflation and inflation looks like a draw so far. The global economy is not slipping into a deflationary abyss. On the other hand, inflationary effects are popping up in numerous inconvenient places.

Based on official US data, the Consumer Price Index (CPI) is up 3.2% over the last 12 months, while the Producer Price Index (PPI) is up 6.8%. Both numbers are higher than in recent history, but neither one seems particularly terrifying…on the surface.

When you dig down into the numbers, however, you discover that these inflation rates are accelerating rapidly. During the first four months of this year, the CPI has jumped 9.7% annualized, while the PPI has soared at a 12.8% annualized pace.

Import prices are also rocketing higher – up 2.2% in April, after a 2.6% jump the previous month. Year-over-year, import prices are up a hefty 11.1%. But once again, the trend is accelerating. For the first four months of this year, import prices have increased at a 26.7% annualized rate!

Let’s put these facts and figures into a real-world context. Based on the lowest of these various inflation data, the CPI, the average US wage earner has made no progress whatsoever during the last four years…

US average per capita weekly earnings have increased about 12% since the beginning of 2006. But since the CPI has increased the same amount, that means inflation has wiped out all the growth of weekly earnings.

If, as we suspect, the forces of inflation continue to prevail in this contest, hard asset investments should perform well, at least relative to most other options. But this analysis is not new news to faithful Daily Reckoning readers. It’s probably not even new news to unfaithful Daily Reckoning readers. (You know who you are!)

We’ve been singing the praises of hard assets like gold and silver for many, many years. In fact, we’ve been talking up had assets for so long that our analysis would be growing tiresome by now…if not for the fact that it has been profitable.

Even so, your editor does not wish to grow tiresome to anyone – not to his kids, not to his girlfriend and certainly not to his Daily Reckoning readers. So he will add a nuance to his monotonous “buy hard assets” mantra.

Here goes: If inflation takes hold as we expect, the allocations in your portfolio that are not hard asset investments should, nevertheless, possess hard asset attributes. When allocating to specific stocks, for example, insist that those stocks possess two key attributes:

1) Significant exposure to non-dollar revenues.
2) Significant pricing power, even in an inflationary cycle.

A strong balance sheet and solid cash flow also help.

Eric Fry
for The Daily Reckoning