by Aaron Katsman on August 29, 2010

We always complain that prices that we pay for goods and services are going up. Listen to the news and you will hear that the price of bread is going up, as is the price of gas, not to mention the price of wheat which has surged to record high prices.  In fact, in order to escape the global economic slowdown, the US and almost every other country, is printing money 24 hours a day, 7 days a week to pay for the trillions of dollars in new government spending. Had you asked an economist a couple of years ago what would happen if the government printed money like this, the economist would have said that inflation would be the result.

We hear the term ‘inflation’ thrown around but what is it and how does it impact our investments?

Inflation is defined as a sustained increase in the general level of prices for goods and services. As inflation rises, every dollar you own buys a smaller percentage of a good or service.

Now funny enough, not only has inflation not materialized, but the same economic pundits predicting its arrival are now worried about ‘deflation’ as the big economic hurdle of our time. Deflation is a decrease in the general price level of goods and services and results in an increase in the real value of money – allowing one to buy more goods with the same amount of money.

How did this reversal of fortune happen? According to the San Francisco Chronicle, “The first thing that happened was a recovery that wasnt really a recovery. The United States has had a number of jobless recoveries over the past 20 years, but this one has been particularly dire and persistent. National unemployment continues to hover at 9.5 percent, and a fuller picture of unemployment and underemployment shows a full 16.5 percent of the workforce in need of a paycheck. Inflation isnt possible when people dont have any money to spend.”

Deflation and Inflation

It actually appears that we have both inflation and deflation happening simultaneously. As I mentioned earlier, food and grain prices are moving higher signaling inflation, but with little in the way of consumer spending or a pickup in employment, deflation seems to be the order of the day.

It’s clear from the recent market volatility that investors are unsure of which ‘ation’ is going to win out. For investors there are things that can be done in both the short and long-term to protect your portfolio against both instances. I think that for the next 12-16 months, the focus will be on deflation. As such investors may want to look at short term corporate bonds as an alternative to cash. Though you may only receive a yield of 1.5-3% per year, in a deflationary climate, that is a very good investment. Remember, this would mean you have increased your purchasing power by this amount. Also preferred stocks with much higher yields can be incorporated into your portfolio, but be sure to keep your finger on the ‘sell’ trigger, because once interest rates start moving higher, preferred stocks can potentially drop in value. And thirdly, in deflationary times, the US dollar is viewed as a safe haven.

Once the economy stabilizes and starts to grow again, then investors should be on the lookout for inflation. No government can constantly print money and create unsustainable debts and escape some kind of inflation. As a hedge for inflation, investors can look to invest in gold—which is probably the most popular inflation hedge. According to Blanchard Economic Research, “Gold is renowned as a hedge against inflation. The most consistent factor determining the price of gold has been inflation as inflation goes up, the price of gold goes up along with it. Since the end of World War II, the 5 years in which U.S. inflation was at its highest were 1946, 1974, 1975, 1979, and 1980. During those 5 years, the average real return on stocks, as measured by the Dow, was -12.33%; the average real return on gold was 130.4%.”

If inflation were to take hold, the US dollar would probably take a big hit. As such foreign currency bonds (i.e. non-US dollar bonds) would be a good hedge against a falling dollar.  These bonds offer higher interest rates than the US dollar and their local currencies would appreciate against the USD allowing for capital appreciation as well.

Aaron Katsman is a licensed financial professional both in the United States and Israel, and helps people who open investment accounts in the United States. Securities are offered through Portfolio Resources Group, Inc. a registered broker dealer, Member FINRA, SIPC, MSRB, NFA, SIFMA. For more information, call (02) 624-0995  visit www.aaronkatsman.com. or email aaron@lighthousecapital.co.il.