Everything Has Changed

Inflation, deflation, stagflation. Lately, it seems all you hear about these days have the words “flation” at the end of it. Its either that or the printing press, QE, Bernanke, the Dollar, commodities, housing, and of course, gold…

Inflation, deflation, stagflation. Lately, it seems all you hear about these days have the words “flation” at the end of it. Its either that or the printing press, QE, Bernanke, the Dollar, commodities, housing, and of course, gold.

In the media, one of the biggest problem our economy faces is inflation. The governments (both in the US and Canada) will undoubtedly have to raise interest rates which cannot remain at these levels.

We’re seeing our purchasing power diminish substantially. Gas prices are too high, food prices are surging astronomically, and everything else just costs more.

Heck, I went to get my haircut the other day and guess what I saw? A big red sign telling me that prices have increased. If my hair dresser is feeling the effects of inflation, imagine what others are feeling?

When you combine the amount of money being printed with an extended period of record low current interest rates, it starts getting scary.

Generally, raising interest rates is the prime combatant of inflationary pressures. In the United States, short term interest rates are decided by the Federal Reserve (see What the Fed Doesn’t Want You to Know by clicking here.)

Interest rates directly affect the credit market (loans) because higher interest rates make borrowing more costly. By changing interest rates, the Fed tries to achieve maximum employment, stable prices and level growth. As interest rates drop, consumer spending increases, and this in turn stimulates economic growth.

Contrary to popular belief, excessive economic growth can in fact be very detrimental. At one extreme, an economy that is growing too fast can experience hyperinflation, resulting in major problems.

But so far, has this happened?

Sure, we’re experiencing some minor growth and a double-dip is unlikely (or so they say). But the fact is, current inflationary pressures are as a result of A LOT of new money being created – plain and simple.

While inflation is a major issue, it is not the only factor informing the Fed’s decisions on interest rates. For example, the Fed might ease interest rates during a financial crisis to provide liquidity (flexibility to get out of investments) to U.S. financial markets, thus preventing a market meltdown. This has been the clear goal of our recent economic crisis.

While the meltdown already happened, the printing of money has stimulated the stock market enough to bring it back to the highs of 2008, and nearing the highs of 2007.

But while the stock market has performed, the economy really hasn’t bounced back as strong. The amount of borrowing by the US is still not enough to get our economies back to where they were just a few years ago. Combine that with the growth our economies need to achieve to replace all the lost jobs, plus the amount of borrowing that’s being done at current interest rates, and we end up with a serious problem.

How does that relate to your portfolio?

The impact of inflation on your portfolio depends on the type of securities you hold. If you invest only in stocks, worrying about inflation shouldn’t keep you up at night. Over the long run, a company’s revenue and earnings should increase at the same pace as inflation. I think we’re already seeing that in our markets. As the money supply increases, so have the prices of everything else – including stocks.

The exception to this is stagflation.

The combination of a bad economy with an increase in costs is bad for stocks (which is what is happening as we speak.) Companies are in the same situation as a normal consumer – the more cash it carries, the more its purchasing power decreases with increases in inflation.

The main problem with stocks and inflation is that a company’s returns tend to be overstated. In times of high inflation, a company may look like it’s prospering, when really inflation is the reason behind the growth (especially when inflation wasn’t created by growth). When analyzing financial statements, it’s also important to remember that inflation can wreak havoc on earnings depending on what technique the company is using to value inventory.

Fixed-income investors are the hardest hit by inflation. Suppose that a year ago you invested $1,000 in a Treasury bill with a 10% yield. Now that you are about to collect the $1,100 owed to you, is your $100 (10%) return real? Of course not! Assuming inflation was positive for the year, your purchasing power has fallen and, therefore, so has your real return. We have to take into account the chunk inflation has taken out of your return. If inflation was 4%, then your return is really 6%.

This example highlights the difference between nominal interest rates and real interest rates. The nominal interest rate is the growth rate of your money, while the real interest rate is the growth of your purchasing power. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation. In our example, the nominal rate is 10% and the real rate is 6% (10% – 4% = 6%).

As an investor, you must look at your real rate of return.

Unfortunately, investors often look only at the nominal return and forget about their purchasing power altogether.

The best way to combat this scenario is to invest in inflation-hedging bets while maintaining your diversity in stocks. This means putting your money in hard assets like real estate or precious metals such as silver and gold while adding stock positions tied to the mining and resource sectors.

As mentioned in the above scenario, If you invest only in stocks, worrying about inflation shouldn’t keep you up at night as a company’s revenue and earnings should increase at the same pace as inflation.

But if you factor in mining and resource based investments into the equation, there is an opportunity to not only beat inflation, but also protect yourself against stagflation.

One could write a 1,000 page paper on inflation, stagflation, or deflation. But the point I am trying to make is simple. We’re in unchartered waters where inflation is apparent but growth isn’t. The Fed is printing money and while it worked on the stock market, it has yet to take any major affect on both housing and employment.

The US’ True Concerns

The Fed isn’t worried about inflation. Its worried about deflation. One look at the housing situation and you can see the pressures of deflation on the US economy. Housing prices continue to drop while no amount of QE or record low interest rates can change that.

No one is buying US treasuries, except for the Fed (see Right Under Your Nose). So regardless of Bernanke’s hint of no QE3, I find it hard to believe it will just end. And if it does, it won’t be long before it comes back. The Fed has no recourse but to continue quantitative easing to avoid an economic collapse. As I have said before, they’ll just call it something else.

And guess what that means?

Stocks will continue to rise. Prices will continue to rise. And Gold will continue to rise.

Even after the recent commodities pullback, gold is once again hovering above $1500. I still think it’s going higher.

Aside from the billionaire investors, pension funds, universities, and private individuals buying gold, the world’s biggest and fastest growing national economies are in the process of accumulating mass amounts of gold.

Regardless of what you read in the headlines, the true buyers of gold are the biggest and fastest growing countries such as China, India, and Russia – not hedge funds and speculative investors.

A few weeks ago, I already told you that China will be diversifying its trillions of dollars of reserves into oil and precious metals (see Age of America Over.) They have already announced an intention to raise their national reserves by nearly 850%, or 10,000 tons by the end of the decade. That’s an estimated half a trillion U.S. dollars worth of gold. In the first two months of this year, China has already boosted their national holdings by 200 tons.

As the world’s largest gold producer, China churned out 350.9 tons in 2010, but it wasn’t enough to satisfy the overall total demand of more than 700 tons. As demand continues to outpace supply, we can expect China to import more bullion. But China won’t tell anyone how much it has bought, until it has actually bought it. Why would they bid up prices amongst themselves? As 2011 moves forward, I expect China to shock the world with a lot more purchases in gold. They’re buying on the dips, why aren’t you?

The Biggest Buyer of Gold

While China as a country is buying big, regular Chinese investors are also snapping up gold bars and coins, buying more than ever before in the first quarter of 2011 and overtaking Indian buyers as the world’s biggest purchasers of the metal.

The World Gold Council said that China’s investment demand for gold more than doubled to 90.9 metric tons in the first three months of the year, outpacing India’s modest rise to 85.6 tons. That means China now accounts for 25% of the world’s gold investment demand, while India accounts for 23%.

Last year, India purchased nearly 750 tons of gold, smashing their previous year’s record by nearly 40%. Russia, not to be outdone, bought up two-thirds of their entire national production. We’re seeing a major change in the world. The developing nations, both Russia and India, want to own more gold. China is undoubtedly doing what it can to beat out the US.

But as powerful and influential as these three developing countries are, they are still under the influence of the US dollar, the world’s reserve currency. That means most of its international business is done using the Greenback…and that means they need to hedge against a falling Dollar.

So even as massive headlines appear, screaming a fall in commodities and precious metals prices, gold keeps climbing.

If you haven’t already jumped on the bandwagon, it’s not too late. Sure gold is at all time highs. But a smart investor knows to buy in a bull market and sell in a bear market.

The bulls are still stampeding. Don’t get run over.

Until next week,

Ivan Lo

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