The Inflation Tsunami (Part Three of Three)

While we are confident in our ability to understand the deleterious effects that the current set of suboptimal policies are likely to have on the global economy over time, we nevertheless don’t purport to know exactly how these policies might change from here or what impact or on what time horizon financial markets will adjust accordingly. There are too many unknowns, too much pure uncertainty. As such, when seeking to protect and preserve wealth, we need to rely primarily on the most fundamental form of insurance available to investors: Diversification.

The problem many investors face, however, is that they have been conditioned to regard diversification in a rather narrow way. For example, instead of buying a single stock, some might seek to buy a stock market index. Yes, this diversifies within stocks but, in a world in which most large companies have huge direct or indirect exposures to the capriciousness of policymakers, does this really diversify the fundamental risk? No. Some investors might diversify into bonds but, if policymakers are seeking higher inflation, at some point these bonds are going to lose a substantial amount of purchasing power. The same is true for cash.

The unpredictability of policymakers’ actions and consequences–negative as they are likely to be in our view–casts a shadow over the entire spectrum of financial assets: Stocks, bonds and cash. What investors need to do is to get some portion of their assets off that spectrum entirely. This is where commodities come in. Unlike stocks and bonds, which pay dividends and coupons, commodities produce no cash flows. Unlike corporations and municipalities, commodities cannot go bankrupt and leave their investors with only a fraction of their investment, if any. Unlike financial assets, the prices of which are necessarily a function of the arbitrary and increasingly desperate policies of central banks around the world, commodities represent real goods, with real supply and real demand. This does not mean that they are always going to go up in price, nor does it imply that they are always going to outperform financial assets. But given the current, unfortunate state of the world, they offer real, tangible diversification in a way that financial assets do not.

Yes, as policymakers consistently choose to pursue inflationary policies, it is more likely than not that inflation rates in future will be higher than those of today. Commodity prices will most likely rise. But we do not presume to forecast by how much, over what time horizon, or what commodities are likely to be the best performers. What pertains to asset diversification in general pertains to commodities specifically. Other factors equal, a larger basket is better than a smaller one.

This is our response to those that claim that gold is the ultimate insurance policy against unsustainable and counterproductive economic policy. History offers much evidence for this claim. Yet it also offers much evidence that blending other commodities with gold can better diversify a defensive investor’s overall portfolio. These other commodities should include metals, both precious and base; energy, in particular crude oil; agricultural products, in particular grains; and other soft or industrial commodities, with the understanding that, as one moves away from those most widely traded, liquidity will decline.

From there, investors can further enhance returns by moving into business investments which represent the various stages of value added for these commodities: Mining, agribusiness, transportation and other infrastructure. Relative to history, stocks for these sorts of companies may be trading at what appear to be lofty valuations, but keep in mind that, if commodity prices continue to rise, those valuations are more likely to be sustainable and, of course, the dividends paid by these firms should continue to rise in future alongside commodity prices and profits, also providing an effective hedge against future inflation.

Regards,

John Butler,
for The Daily Reckoning

[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]