Sunday, July 01, 2007

Inflation and Investing

There is a ton of talk on the internet and on the news about inflation. The government reports that core inflation is around 2% annually, but if you look at how those numbers are derived, you end up scratching your head. The bundle of goods in the inflation basket do not include many things in daily living. Core inflation does not include energy, food, medical necessities, but does include electronics, which I know everyone buys every single day. At the big picture, this is called inflation ex-inflation. The idea that the government records inflation without the items that have been feeling the effects of inflation. What is nice is that even mainstream media has caught onto this song and dance, and is skeptical of the government data and beign critical of the information provided and its use in policy making.

Well, how does this affect investing? It means that for your investments just to keep up with inflation, you're going to have to have higher returns. If the stock market gains 5% and inflation is 5%, you're running in place. If your bond yield is 4% and the true inflation rate is 5%, you lost money. Bonds should play a role in everyone's portfolio, even 20 something youngsters. My retirement portfolio probably has a 15% bond allocation. I look at bond's as a way to stabilize, just a touch, my portfolio. Right now many bond funds are returning 4-5%, and if you doubt govt number on inflation, you're treading water right now. An investor could reach for yield with junk bond funds, but those funds are not returning double digit percentages in yield. The spread between junk and quality debt is extremely low by historical standards, and the risk for default this late in the economic cycle is higher than it was 3 years ago. Vanguard's index funds for taxable bonds shows a 2% spread between high yield and normies. Not a lot of reward for a lot more risk.

A rec I have is for foreign bonds of high quality, and this is only because I am a dollar bear. The dollar is due for more loss of value as our Fed refuses to raise interest rates as other banks tighten their monetary policies. Add to that our printing press approach for money creation, and I think this means foreign holdings will increase in value due to exchange rate settings. One could argue that if foreign holdings will get a boost from the exchange rate, one might as well invest in equities. Equities have a far greater opportunity to outpace inflation, and return more bang for your rapidly depreciating bucks.

No comments: