Thursday, May 28, 2009

The Price of Recovery: Are You Inflation Ready?

From USAA.com:

In the first quarter of 2009, consumer prices, as measured by the Consumer Price Index, decreased by 2.4%. The Personal Consumption Expenditures Price Index, the Fed's preferred inflation gauge, was down 1%. The most recent data shows there is no evidence of inflation in the U.S. economy.

The government is spending trillions of dollars using a broad swathe of initiatives to fight deflation, which is the opposite of inflation. And therein lies the rub. Should the government's efforts succeed, and there are some signs that they may, the huge new debt issuance that's supporting them could lead to a spike in inflation that we have not experienced since the 1970s.

The deftness and agility that will be required in the pivot from fighting deflation to fighting inflation is tremendous. In essence, the government has to provide enough monetary stimuli to get the economy firmly on the growth path, while standing ready to reverse course without stepping on the recovery. At USAA, our view is that the government will err on the side of letting inflation run a while, rather than risk a double-dip recession.

In response, we are acting now to build additional inflation-protection tools into our asset allocation products. In doing so, we are being driven by the following principles:

While inflation is not likely in the next few months, it is the likeliest outcome over the mid- to long-term.

U.S. Treasury-backed securities without inflation protection are probably in a bubble, and will suffer price declines amid all of the new issuance when the Treasury and the Fed take their foot off the monetary gas.

There are certain asset classes that should perform better than others in an inflationary environment, and it will be important as asset allocators to have the ability to shift assets to these vehicles across our product lines as the deflation/inflation pivot occurs.

USAA: Building an Intelligent Inflation-Fighting Toolbox

As always, we study what's happened in the past as a strong guide for how markets will behave in the future. Here's a rundown of how some important asset classes have performed.

Common stocks overall have had no correlation with inflation since 1926. We believe that our preference for active management would benefit given our sub-advisers' abilities to shift among sectors. For instance, exporters would benefit from the fall in the dollar that would accompany inflation, as would commodity-based companies in growth-driven markets.

Real estate has been positively correlated with inflation, as both rent and value tend to go up along with rising prices in other portions of the economy. The data on equity real estate investment trusts is less conclusive, and in fact these vehicles have been uncorrelated with inflation since 1972. We think recent changes in equity REIT structures should make them perform more like direct real estate in a coming inflationary period.

Gold is positively correlated with inflation, and also acts as a currency substitute that would rise in the face of a falling dollar.

Commodities have a relatively strong correlation to inflation, and are especially good for inflation caused by excessive demand, as opposed to inflation sparked just by increases in money supply. Commodities are also a powerful diversification tool, since they are negatively correlated with both stocks and bonds.

Bonds tend to suffer because inflation eats into the purchasing power of both income and principal repayment. Shorter-term bonds do better than longer-term issues, bonds with credit risk are less sensitive to inflation and rising rates than Treasuries, and there is a new class of inflation-linked securities and derivatives, including Treasury Inflation-Protected Securities.

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