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A Strategy For Inflationary Times

Retro styles are in vogue. Unfortunately, so are retro economic conditions. The world, and the United States in particular, may be entering an era of higher inflation much like the 1970s.

Need proof? Gusher-high oil prices. Check. Continually rising food and commodity prices. Check. Collapsing dollar. Check. Fondue is popular. Check.

While we cannot see the future, we can use the 1970s experience to help us guard against the damage persistent inflation can do to our investments. At Palisades Hudson, we are adjusting our strategies to strengthen clients’ inflation defenses while we continue to pursue long-term growth.

Two types of inflation may affect Americans: global inflation and local inflation. There is very little we can do to stem global inflation. Until recently, worldwide inflation was tempered by the availability of cheap goods, particularly from Asia. That is changing. China’s rising wages have begun to pass through to its exports. Additionally, as the standard of living in China and other Asian nations increases, their residents become consumers, resulting in rising worldwide demand for energy and commodities such as oil, copper and meat. Finally, China, which kept its currency pegged to the U.S. dollar at an artificially low rate, is letting it slowly appreciate, and Chinese goods will become more expensive as a result. The $17 men’s swim trunks at Wal-Mart could soon sell for $20. Consumers worldwide are likely to see this inflation.

Local inflation arises from country-specific reasons, such as a falling currency. The weak dollar means Americans now have less buying power to purchase these suddenly not-so-cheap imports. And even though the greenback recently has been at multiyear lows, more dollar pain may be on the horizon. For 50 years, the dollar was the world’s dominant and most stable currency. Investors worldwide loaded up on dollar reserves, typically in the form of Treasury securities, keeping U.S. long-term interest rates low. America grew complacent, hooked on a seemingly endless supply of cheap money from abroad. The Federal Reserve kept money flowing and short-term borrowing costs too low for too long, driving down the dollar’s value.

Foreigners are watching their U.S. investments lose value because of a falling currency and rising inflation. At the same time, we continue to borrow from the rest of the world to finance our trade deficit. At some point, which is nearing, foreigners may decide it is no longer the safest course to keep most of their reserves in American investments. As they dispose of their dollars, the already-damaged currency may well fall farther.

To fight inflation, the Federal Reserve will raise interest rates at some point. This will make certain investment projects unprofitable and has the potential to stall the economy, which is just what happened at the end of the 1970s.

Investors must invest in something. The big three options are stocks, bonds and cash. When we allocate investments among those classes, we seek to balance the investor’s desire for long-term growth with his or her aversion to risk and need for readily available cash. This asset allocation is the fundamental decision for each portfolio. We usually change it only when the investor’s personal situation changes. The mere fact that we see a heightened risk of long-term inflation will not lead us to change the overall asset allocation in most cases.

Though expectations of higher inflation can drive down stock prices in the short term, stocks are nevertheless the best way for most investors to maintain their portfolio’s purchasing power. Given time, companies can adapt to higher inflation. In contrast, conventional bonds with fixed interest rates will suffer greatly amid rising inflation. (For more on fixed-income investing in an inflationary environment, please see the accompanying article on Page 7.)

If we are entering a period of higher U.S. inflation, it is worthwhile to review the experience of January 1970 through January 1981. During that time, inflation averaged 7.8 percent annually. The S&P 500 returned a similar amount, which equates to a zero percent return after adjusting for inflation. International stocks returned an inflation-adjusted 3 percent annually, on average. Real estate securities and stocks in the natural resources sector returned 5 percent annually, on average, after adjusting for inflation. U.S. small companies performed well during this period, returning 6 percent annually, on average, despite extreme volatility.

U.S. Stocks

Large American companies tend to be more stable than smaller companies because they have more diversified business lines and customer bases, economies of scale and higher barriers to entry by competitors. They also obtain more revenue overseas than do smaller U.S. companies, which will mitigate damage from any U.S. economic decline. In 2006, companies in the S&P 500 derived 45 percent of their sales overseas. For example, IBM completed 63 percent of its sales overseas. ExxonMobil (69%), Colgate (66%) and General Electric (50%) all generated substantial overseas sales. Therefore, we have only slightly reduced our typical weighting to U.S. large-capitalization stocks, from 45 percent to 40 percent.

U.S. small company stocks have long been a component of our equity portfolios because we expect them to earn higher rates of return for long-term investors. Because we are long-term investors, we can accept the higher volatility associated with small-capitalization investing. The 1970s actually produced better-than-trend-line performance for small-cap stocks, but we believe this is an anomaly that is unlikely to occur in a similar environment today. If inflation heats up during the next decade, we believe smaller U.S. companies will struggle with higher interest rates and their reliance on domestic consumers. We have reduced our weighting to U.S. small-cap stocks to 10 percent in many portfolios.

Together, U.S. large-cap and U.S. small-cap investments that are not dedicated to the real estate and natural resource sectors represent about half of our clients’ equity portfolios, a decrease of 15 percentage points from 2006.

Foreign Stocks

We have long believed that all diversified investment portfolios should have significant exposure to non-U.S. companies. While America is among the most innovative and business-friendly nations, the rest of the world is narrowing the gap. The United States has successfully exported free-market principles, from which Americans have benefited through reduced trade barriers that make more U.S. goods and services available globally. But the free market also has made countless imports available to U.S. consumers. Now, the rest of the world competes more fiercely with us.

As U.S. economic dominance is reduced, capital will flow to other regions. This will put greater pressure on the dollar. Countries such as China, Saudi Arabia and the United Arab Emirates have pegged their currencies to the dollar. Thus, as the dollar depreciates, these countries experience higher inflation, currently at record levels. Kuwait, in an effort to contain rising inflation, dropped its dollar peg last year in favor of a basket of currencies. Still looming is the possibility of a single Persian Gulf currency, which would further pressure the dollar. For a discussion of foreign central banks’ U.S. dollar reserves, please see Larry M. Elkin’s “Bernanke & Co. Play A Confidence Game” in the April 2008 issue of Sentinel ([posturl id=184]).

We are increasing our non-U.S. stock exposure to as much as 35 percent in most portfolios, a 40 percent increase since 2006. Within the international stock allocation, we are now devoting much more to Asia. As technology improves and free-market principles spread, the developing world will have a greater impact on the global economy. Currently, China and India account for only 15 percent of world output, but their economic expansion represents more than 30 percent of global growth. Our allocation to Western Europe has declined significantly, while we have increased our allocations to Canada and Latin America. These new allocations more accurately reflect world stock market capitalizations and expected future growth.

Real Estate And Natural Resources

Real estate and natural resources securities performed very well during the 1970s. Companies in these sectors own, create or extract the underlying hard asset that serves as a hedge against inflation. For real estate, not only will the underlying value tend to increase with inflation, but cash flow may also increase, as rents and leases often include inflation escalators or periodic renewals at higher prices.

Across several portfolios, we are boosting our real estate allocation to 7.5 percent, allocating one-third to non-U.S. real estate securities. Also, we will have additional exposure to real estate securities through our diversified U.S. large-cap, U.S. small-cap and foreign investments.

While oil sat comfortably above $125 per barrel and commodity prices were at record levels as of last month, a contrarian would rightfully question the wisdom of increasing any allocation to this energized asset class. Many investors wonder whether speculators have significantly contributed to the recent outsized returns. Those short-term investors often evaporate once the next hot investment comes along.

During the 1970s, commodity prices rose 600 percent, mostly as a result of inflation. The Consumer Price Index doubled, while stocks and bonds advanced nearly 80 percent. This time, there is a broad-based change in demand from developing nations. Therefore, we can hedge an inflation risk and capitalize on global growth trends by boosting our discrete allocation to natural resources to 7.5 percent in many portfolios. Also, we expect our diversified investments in U.S. large-cap, U.S. small-cap and foreign stocks will add 11 percentage points of natural resources exposure to our overall equity portfolios.

While buying pure commodities such as gold and corn will ensure direct exposure to inflation hedges, we generally forego direct exposure in favor of enterprises engaged in selling or extracting the underlying hard asset. These businesses can generate profit even if commodity prices decline.

We believe these changes should allow our clients’ portfolios to perform significantly better than they otherwise would have in a high-inflation period. However, we cannot be sure that inflation really is coming back. What happens if it does not?

The lion’s share of our portfolio management is risk management. Before we make a significant move, we try to quantify the risk of being wrong. To do so in this case, we can compare the results of our previous equity asset allocation to those of the new investment strategy during a period of low inflation.

Inflation averaged 2.8 percent annually during 1990-2005. This is below the long-term average, which has been 3.1 percent since 1926. During the 1990-2005 period, our new asset allocation strategy would have trailed our previous strategy by 50 basis points (0.50 percent) per year. We consider that the cost of being wrong on our inflation thesis, a cost we can tolerate.

To be sure, we hope we are wrong and that 1970s-style inflation does not return. For now, we will aim to protect our clients’ capital while still seeking to grow it. Chocolate fondue, anyone?

If you enjoyed this article, be sure to check out Palisades Hudson’s books, The High Achiever’s Guide To Wealth and Looking Ahead: Life, Family, Wealth and Business After 55. Both are available in paperback and as e-books.