Monday, 3 June 2013

Your Investment Strategy May Need an Overhaul - Inflation is Here to Stay

There is much to remember about the 1970s: disco, hairstyles, Archie Bunker. And much to forget, like double digit inflation. Since the Federal Reserve vanquished inflation in the early 1980s conventional wisdom has held that the problem was gone for good. The roaring 90s was the nail in the inflation coffin: low inflation, low unemployment and soaring asset prices.
But somewhere along the way $4/gallon gas showed up. Food prices continually shock and dismay shoppers accustomed to significantly more discretionary spending room. Young adults who have experienced nothing but prosperity are suddenly initiating conversations with their elders about how to cope. And in the process, bringing back those painful memories.
While the 1990s are often remembered for a through-the-roof stock market and low inflation, the truth is that inflation was actually quite high. Market appreciation is itself a form of inflation, one we enjoy more than dread. But too much of a good thing can be deadly. That stock market got out of control and led to the dot-com bubble and bust. 
Where did it come from?
The answer is too much money. Again, too much of a good thing can lead to dire circumstances. For the entire decade of the 1990s the Federal Reserve allowed the money supply to grow faster than needed. That produced the dot-com fiasco. In the early part of this decade the Fed implemented stimulative policies that exacerbated the problem. The housing bubble was another direct result of too much cash, and another form of inflation.
Now that it, too, has burst the problem of too much money is manifesting itself outside of asset prices and into consumer prices. Without stocks or houses to soak up the excess cash investors are turning to oil and energy, food and commodities, etc. If restrictions on the money supply are not put into operation the problem will only worsen. But the Fed is too preoccupied with the credit crunch to change its stance.
For investors that means living with uncomfortable inflation. Over the next several years we can expect interest rates to increase, corporate profits to come under pressure, and price-to-earnings multiples on stocks to decline. That is not a great recipe for stock investing so those investors who need cash to fund living expenses should seriously rethink their investment strategy. 
The good news is that higher interest rates are a good thing, at least for fixed income investors. Interest rates have been historically low for the better part of this decade, causing much angst for bond and preferred stock holders. A return of more normal rate levels can present an opportunity for investors needing income, and a chance to adopt a new investment strategy.