Download 140410-Inflation-the-Oldest-and-Most-Powerful-Force-in

Inflation, the Oldest and Most Powerful
Force in the Galaxy
By A. Michael Lipper, CFA
Categories: History & Geopolitics
We may believe that inflation is a relatively new phenomenon, one from the time
of the birth of coins and currencies. But evidence just revealed this week proves
that Albert Einstein was correct in suggesting that it was present in the original
Big Bang at the creation of our universe. This week, according to James Bock, a
Caltech* physicist who is working with a team of researchers using a telescope
from the South Pole, evidence of gravitational waves was observed for the first
time. Dr. Einstein predicted the waves a century ago and posited that they were
a direct result of the Big Bang that created our universe. I will leave to others
more learned than me to explain the theory.
For those of us that live in the world of numbers and taxes, the key to the
discovery was the term used for the exponential growth of particles that became
planets and other objects. That term was “inflation.” Thus, the term from the
physical world describes a power that keeps growing.
Inflation: The Political Crutch
I have read a number of constitutions from around the world, and in none of them
have I found that the sacred duty of the government is to create jobs for the
governed. Yet any government that wants to stay in power, whether elected or
not, is at risk when people are out of work and there is general lack of sufficient
food. The leaders of the government, rather than to solely rely on the underlying
economy to produce sufficient income and jobs, believe that they must do it. In
general, governments have two sets of financial tools: fiscal and monetary
policies. Fiscal policies are those that set the level of taxes raised from the
population. Because most people do not want to give up some of their hardearned money to the government, raising net effective tax rates is generally not
favored.
The second set of policies is monetary policies. These deal with the levels of
loans made by the financial community and, in essence, the value of money.
There is a long history of the latter. A monetarist would point out that the Roman
Empire, like all great empires, did not fall to hordes of barbarians. Rome fell
because, for many years, the government was literally shaving some of the metal
from its coinage money. In effect it was devaluing the currency. The public was
not dumb and realized that the value of the money declined, and so they raised
the prices for their goods, services, and labor. Rome fell because it could no
longer be protected by the best (and most expensive) military in the world.
In the Middle Ages, shaving coins was punishable by death. A government that is
not popular — and few are — can either publicly raise taxes or more quietly
devalue currency, which creates inflation. Too many of today’s leaders are
unwilling to pay for current and future government services through tax revenues
and so resort to forms of inflation that the public does not fully comprehend.
Central banks, which are (as their names suggest) responsible for monetary
matters and in theory independent of political forces, are in fact beholden to
political forces. Because the political leaders can not obtain sufficient taxes, they
have the central banks induce inflation in the economy; they hope inflation will
stimulate individual and corporate savers to spend and invest, which will create
new jobs and incidentally lower the value of their debt repayments.
The Enemy
In a closed society that is not expanding, the need for increased spending and
investment is high. By definition, the people who have the necessary money are
the savers. These people are those who are choosing not to spend in order to
provide for the future spending needs of themselves, their families, and
worthwhile charities. By lowering the value of their savings by inflation, central
banks are in effect stealing from these savers. Thus, the savers become the
target to generate the future growth. If they don’t readily provide the necessary
funds, they become the enemy.
The current policies of many central banks, including those in United States,
United Kingdom, Europe, and Japan, is to raise inflation to 2% or more to drive
their economies. The theft becomes apparent when you start to understand the
long-term effects of inflation. The collapse of the Weimar Republic in Germany
brought Hitler into power when German money was practically worthless. Many
would say that can’t happen here. If successive central banks meet their goals of
2% or more inflation, in one or two generations the entire wealth of the savers
can be wiped out.
The rule of 72 shows the number of years it takes to double your money by
dividing the current or expected interest rate into 72. The same calculation can
be used in reverse to see how long it would take to lose half. Two divided into 72
suggests 36 years. For those of us responsible for long-term investing for
endowments or multiple generations of families, 36 years is a short term when
100-year bonds are being eagerly sought.
How an Award Winning 401(k) Invests during Inflation
There is no complete solution to creating an investment portfolio that can meet
the needs for reasonable returns in spite of the risks of inflation. We have
addressed these needs in a 401(k) that BrightScope labeled as the best in the
country in terms of many attributes, including low costs.
As the participants can not withdraw their money from this plan for ten years, the
ten-year performance numbers are relevant as a guide for long-term-oriented
accounts. Below is the annualized performance for ten years through the end of
February of the nine options offered to the participants and their rank within the
nine alternatives:
Total Reinvested Return
1. Small-cap core = 9.23%
2. Small-cap value = 8.23%
3. Index fund = 7.89%
4. Growth = 7.76%
5. Value = 7.07%
6.
7.
8.
9.
Balanced = 6.71%
International = 6.27%
Bond = 4.73%
Stable Value = 3.10%
Do not fixate on the actual numbers, which were influenced by numerous special
circumstances. During the last ten years I have been very concerned that afterinflation returns were going to be important for all of our accounts to meet their
spending needs beyond the financial world. To me, the best overall way to do
this was to assume more volatility and liquidity risk by investing in smaller
companies.
In any given ten-year period, the actual returns will almost certainly be different,
as will probably those ranked between 3rd and 7th. As the end of this period was
February, the ranking of International was hurt by currency movements.
Believing that the United States will not adequately address its inflation issue,
which should be zero based, I believe on a relative basis the long-term value of
the dollar will decline. Thus, at this point in time for long-term accounts I would be
increasing exposure overseas, even with the economic and credit risks in China.
The Bond return of 4.73% includes significant investments in TIPS to provide
some real return benefits from owning bonds. Because I expect interest rates to
rise, the total reinvested return in bond funds in a cash flow account will enjoy
higher rates, which can offset some lower bond prices. Stable value returns over
time should equate to the inflation rate.
Are there other long-term oriented 401(k)s with which we should be speaking?
Other Currencies
The way we invest into non-US-dollar currencies is through funds that have
equity and debt positions in selected currencies. Because the US dollar is the
temporary safe currency, it has appreciated against other currencies. This means
that the other currencies have lost value relative to the greenback.
I like to buy when things are down, so I am attracted to investments in sound
Canadian companies. The relatively newly appointed head of the Indian Reserve
Bank appears to be making India’s securities more attractive by raising interest
rates, as some investors may want to diversify out of some of their direct
holdings in China. Along the same line of thinking, the Taiwanese dollar could be
of interest.
My question for all of us is: How are we going to hedge our inflation risk ahead of
inflation manipulation replacing interest rate manipulation?
Please share your thoughts.
When he came to the United States, Albert Einstein spent some time at the
California Institute of Technology (Caltech). I have stayed in the suite that was
prepared for him in the faculty club on campus. Princeton lured him away to
teach in New Jersey, where we now live. The Big Bang Theory, which much of
his work influenced, is used as a title for a current television comedy about very
bright scientists adjusting to functioning in the everyday world. I will admit my
good wife is addicted to watching both the original and re-runs of this hilarious
show. Many believe that Caltech graduates are the models for these characters.
There is much amusement about the success of the program at Caltech board
meetings that I attend.
*