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July 01, 2009 at 04:00 AM
Members of the Retirement Income Industry Association and friends keep asking me a difficult question: Are retirement portfolios more at risk from inflation or from deflation? Look around, are your clients worried about inflation or do they seek protection from deflation? Some fear Weimar-like hyperinflation caused by excessive government spending. Others fear Great Depression-like deflation from unprecedented levels of stranded debt and de-leveraging. What is it going to be?
Some people become accidental tourists. Five years ago I became an accidental lecturer, when I began teaching each spring a master’s program class in investment management. The class, “Principles of Finance,” covers topics including corporate finance, the markets, the major asset classes and portfolio management. The students are young professionals mostly in their late twenties and early thirties. They want to advance their careers to become portfolio managers. They are an interesting group. Many work for RIIA members and I learn a lot from them. Teaching is a good way to learn. Students ask questions and seek answers in ways that will surprise but never disappoint.
The material makes it clear that one has to form an opinion in order to manage money. Going with the common wisdom is not enough. Going with the flow may feel good but will it make money? Acting based on the comfort of the common wisdom will, most likely, not help returns that come from buying low and selling high. One has to “zig” when others “zag.” This means forming a personal opinion that may not agree with the common wisdom. As one student put it, we must defy what John Maynard Keynes observed: “Worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally.”
As a class exercise, we all tried to form a personal opinion about inflation. We discussed questions such as these: How long will we experience inflation or deflation before we no longer do and why? What will come next and for how long? Soon, you realize that forming an opinion is always subject to change as new evidence is revealed.
Money, Credit & Expectations
Sources peg the amount of American money circulating around the globe at a number between $1 trillion and $2 trillion. Can we buy more or fewer goods with this money? Looking online, students found analyses substituting the Case-Shiller housing index for the Owners’ Equivalent Rent that’s used in the Consumer Price Index; for February 2009, this adjusted measure of inflation fell at a negative 5 percent, year on year, for the third straight month. Looking for other measures, some students created analyses comparing 10-year Treasury yields to TIPS. These analyses suggested, as of March 2009, an implied and rising “five-year, five-year-forward break-even” inflation rate of about 2 percent, meaning that inflationary expectations are on the upswing.
Also, sources peg the recent peak amount of total American debt at or above $50 trillion. While both money and credit can be used to buy things, they are not the same thing. Clearly with a credit-to-money ratio of 25-to-1, credit deleveraging is bound to have a big deflationary impact.
Taking a step back, other students focused on the current and unprecedented government bailout commitments currently estimated above $10 trillion and counting. If one were to add government entitlements such as Medicare, Social Security and public pensions, we have combined obligations that may be larger than $60 trillion. How will we pay for these obligations? Will solutions be deflationary (because of higher taxes and a depressed economy) or inflationary (because of printing more paper money)?
