Inflation, the Oldest and Most Powerful Force in the Galaxy by A. Michael Lipper, CFA
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 hard-earned 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.
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
- Small-cap core = 9.23%
- Small-cap value = 8.23%
- Index fund = 7.89%
- Growth = 7.76%
- Value = 7.07%
- 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 after-inflation 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?
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.
This was previously published on Inside Investing at the CFA Institute.
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A. Michael Lipper is a CFA charterholder and the president of Lipper Advisory Services, Inc., a firm providing money management services for wealthy families, retirement plans and charitable organizations. A former president of the New York Society of Security Analysts, Mike Lipper created the Lipper Growth Fund Index, the first of today’s global array of Lipper Indexes, Averages and performance analyses for mutual funds. After selling his company to Reuters in 1998, Mike has focused his energies on managing the investments of his clients and his family. His first book, MONEY WISE: How to Create, Grow and Preserve Your Wealth was published by St. Martin’s Press. Mike’s unique perspectives on world markets and their implications have been posted weekly at Mike Lipper’s Blog since August, 2008.
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