July 26, 2011
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What do we plan to do with client portfolios in the event of very high inflation? This question, which has been posed by our clients, is timely. Almost all the analysis we read has concluded that, with the Fed seemingly printing money out of nowhere, the inevitable consequence must be significantly higher inflation.
We’re not convinced, but we have identified which strategies are likely to best protect clients if inflation accelerates.
At the moment, inflationary pressures are advancing, with the year-over-year increase in the CPI running at 3% and rising. The chart below, which illustrates the Inflation Timing Model from Ned Davis Research, also shows high inflationary pressures.
Thus far, however, inflation has not manifested itself into higher interest rates. Quite the contrary. Since February 9 of this year, the yield on the 10-year Treasury note has dropped from 3.74% to under 3%. Some of this drop may be attributed to QE2, but more recently, several economic reports have shown concern about a weakening economy, which would be deflationary, not inflationary.
Let’s look at how various investment strategies have fared under inflation and its byproduct, high interest rates.
The historical record on investing during inflationary periods
My research shows there have been only two periods in modern financial market history (since 1926) in the United States that have had significant bouts of inflation: from 1941 to 1947, in the aftermath of World War II, and from 1973 to 1981. The latter period will probably resonate more with readers, because even those who may be 64 or older today are not likely to remember the 1940s.
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