Inflation: The Unwelcome Houseguest

Gold and Silver Bullion make a good speculation in times of inflation...

MAKE NO MISTAKE, writes Martin Hutchinson at Money Morning. Inflation is coming your way.

This insidious increase in the general level of prices is currently rattling around the world's emerging markets. Inflation is causing China and Brazil to put up interest rates, while India is trying to suppress it with price controls. It's also beginning to appear in Britain, which had a similar crash to the United States, but where the currency has been somewhat weaker.

Within the next six months – while the US Federal Reserve is still buying US Treasury bonds under its "quantitative easing" policy – this inflation tsunami will hit the United States.

Inflation is a lot like the unwelcome houseguest: Once you invite it into your home, you can't get it to leave. The key catalysts for the inflationary visitor that's headed our way are the silly-money policies that the Fed and other central banks have been pursuing. Those policies have inflated yet another massive bubble – this one in the commodities sector. All the cheap money that's right now sloshing around the global markets have sent commodity prices into the stratosphere, and are causing emerging-market economies to grow like crazy.

Inflation was especially virulent in the 1970s, when rising prices and high unemployment combined to cause the particularly odious form known as "stagflation." It certainly didn't help that it took policymakers almost the entire decade to face up to the fact that inflation wouldn't go away on its own.

Indeed, it wasn't until we got Paul A. Volcker in as Fed chairman in 1979 that inflation even had a worthy foe. It was Volcker who eventually crafted the aggressive policies that were required to vanquish the inflationary pressures that had gripped the US economy for so long.

This time around, unfortunately, the US central bank appears to be even more determined to ignore inflation's early warning signs, while the banks and the politicians will fiercely resist higher interest rates, the only known remedy, because of the dangers of a further housing collapse.

So we can expect inflation to be with us for several years this time, too. In fact, expect it to get worse for the next three to four years, while Ben S. Bernanke remains at the helm of the nation's central bank. Bernanke's term as Fed chairman ends in January 2014; hopefully, whoever is the US president at that point won't reappoint him.

But we'd better arrange matters so we don't lose out from it. As investors, the main problem we have with inflation is that any contract written in nominal Dollars will rapidly decline in value. Long-term bonds are the classic losers from periods of inflation; their nominal value declines, and their prices decline, as well, because inflation pushes up interest rates.

My great-aunt Nan, a splendid lady, retired at 65 in 1947 – at the beginning of Britain's postwar inflationary surge, with ample retirement savings – invested in a 3.5% War Loan government bond, the normal safe-haven for British savers in the 19th and early 20th centuries.

She made it into the 1970s, bless her. But by the time she died, not only was the income from her War Loan worth a quarter of its 1947 value, but its capital value had also declined in nominal terms to about 30% of its 1947 level, as interest rates had risen from 3.5 to 12%.

(Little wonder the British newspaper, The Independent, once wrote that "over the years...the War Loan is a monument to the poor investment value of government stocks.")

Don't let this happen to you! If your money is in bonds – whether those bonds are US Treasuries, municipals or corporates – I'd urge you to move it somewhere else. And if you have the sort of solid final-service pension that companies used to give out and the government still does, check the inflation protection. If the pension doesn't have a 100% protection against inflation – however high it goes – you have a problem.

In the face of rampant inflation, many stocks won't be an answer, either. Theoretically, if your company is making tangible things from tangible factories, or providing tangible services (and not just sitting on a bunch of loans and bonds), then its earnings (and therefore its overall value) should rise with prices. In practice, however, this often doesn't happen.

For one thing, many institutional investors use the so-called "Fed Rule" for determining share price values, which divides the expected future earnings stream by the current interest rate (Future Earnings Stream/Current Interest Rates = Share Price Value).

That's why stocks behaved so spectacularly in 1982-2000: As interest rates came down the "denominator" of that value equation got smaller and smaller – which made it easy for the share price value to go up. But there's a problem: That formula uses "nominal" – not "real" – interest rates. It also fails to account for cuckoo Fed policies, so if interest rates are exceptionally low for a long period, the formula says share prices should go up and up. And if the interest rate is close to zero, the share "value" should be close to infinity!

With the return of inflation, nominal rates will have to increase to keep pace. And real interest rates will have to do the same as Volcker-esque monetary policies are used to get inflation under control. So share prices will almost certainly decline sharply in real terms, just as they did from 1966-82, even though nominal share prices remained approximately flat.

Gold and Silver Bullion are a good speculation in times of inflation, but they don't a good investment. Before 1914, when the world was on the "Gold Standard", the gold market was approximately in equilibrium at a price of just under $19 per ounce. US consumer prices have increased 22-fold since then, so a price of $418 per ounce today would be fully justified. You see the problem?

In practice, the increase in world population – by about 3.7 times – since 1914 should have caused the Gold Price to increase approximately in tandem. That's because the world's gold supplies have not increased, but its population has. That would justify a price of around $1550 per ounce today. This calculation suggests gold is a good buy currently, but if inflation returns and money stays cheap, the price of gold is going to be far above that level quite soon, and buying gold will have become a very speculative activity. At $3000 per ounce, gold would be a hugely risky investment.

So what's the best investment to make right now? In my view, a house.

The US housing market has bottomed out – or, at worst, is close to doing so. And you can get a fabulous rate on a 30-year mortgage, making you benefit from inflation just as bondholders lose from it. The combination of a relatively depressed housing market and cheap money is uniquely favorable, so you should take advantage of it. For the best investment, you can narrow the recommendation further:

• Don't buy around Washington: The market has been pushed up by the flood of bureaucrats and lobbyists that have taken up residence inside the Beltway – an influx that will reverse itself as the US budget is finally brought under control.
• Don't buy in Manhattan or the Hamptons: Prices have been pushed up by all the silly money sloshing about in financial services, which will disappear with higher interest rates.
• Don't buy in Silicon Valley: That advice holds true there, and anywhere else where local wealth has been inflated by stock options.
• Do buy in a medium-sized town: Make sure that town is in an area where the economy is not dependent on finance, the government or energy/commodities.
• Do buy an old house, instead of a new house: Buy an old rather than a new house – the supply of old houses is fixed, whereas new McMansions will appear in profusion and flood the market while interest rates remain low (developers all have large land banks they want to develop.)
• Do take a 30-year fixed-rate mortgage: In a time of inflation and low interest rates, a long-term, fixed-rate mortgage is a gift from above.
• Don't overextend yourself financially: There could be big recessions in the next few years, so you need to be able to make the payments without selling the house.
• Do be prepared to rent, rather than sell: If you have to move in the next few years, become a landlord and rent the house out instead of selling it outright. Rents have been pretty well flat in the last 10 years; they are likely to beat inflation in the next 10 years, since higher interest rates tend to push rents higher.

Readers often wonder if we follow our own advice. Money Morning has a very good rule, which says that I should not deal in any stocks that I recommend to you. But in this case, I'm happy to be able to report that I am practicing what I preach – I'm taking advantage of the current climate to relocate...and am in the process of buying a house!

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