Author: Charles Sizemore
Covestor models: Sizemore Investment Letter and Tactical ETF
I know in advance that I’ll get hate mail for writing this article, but I’m going to do it anyway. It’s a subject important enough to justify the inevitable abuse. You bet the wrong way on inflation, and it may cost you your nest egg.
Inflation is one of those topics best not discussed at the dinner table or in polite company. Like politics and religion, it tends to get a heated response.
In fact, inflation tends to have quite a bit in common with politics and religion. It’s remarkably hard to prove one’s views on any of the three empirically. Truth is accepted as an article of faith. For example, it is accepted as dogma that loose monetary policy causes inflation. The great prophet Milton Friedman said so himself: “Inflation is always and everywhere a monetary phenomenon.”
Not shockingly, Mr. Friedman’s disciples have been on edge for the past three years, waiting for inflation to come roaring back. True enough, there has been inflation in energy and food prices—the two consumer segments most global in nature and most subject to increased demands from emerging markets (and in the case of energy, the segment most susceptible to geopolitical risks). But overall consumer prices have been flat since the onset of the 2008 meltdown, and most retailers find they have little pricing power. If they want to move the merchandise, they have to keep their prices low.
Don’t expect this to change any time soon. The Financial Times reported this week that the world’s major banks would be shrinking their balance sheets by a trillion dollars over the next two years. Yes, “trillion,” with a “t.”
It’s not the amount of money created that causes inflation; it’s the amount of money that actually enters the financial system. And right now, Wall Street and London’s City are not particularly interested in getting it there. In fact, their attempts to shrink their balance sheets have had precisely the opposite effect, actually removing liquidity from the system.
Housing continues to be a drag on money creation as well. Even though the housing market is showing signs of life, American homeowners are far more interested these days in paying down their mortgages than extracting equity with new debt. (As an aside, I continue to recommend rental housing as an investment for those readers willing to be patient and get their hands a little dirty; see “Here’s the Catalyst for a Housing Rebound”).
Someday, we will have real inflation again. But it might take a lot longer than you think. Japan has struggled with on again-off again deflation for much of the past two decades. (see “Japan’s Endgame” for a longer explanation of Japan’s woes).
Japan had a unique and deadly cocktail of high debt, aging demographics, and bad policy that led to its 20-year stagnation, and the United States is certainly not Japan. Still, my point stands: even in a modern economy, high inflation is not the inevitable outcome of loose monetary policy. And given the continued deleveraging of the private sector, inflation in the United States and Europe is likely to be mild at worst.
So, with that said, how should investors position their portfolios?
In recent articles, I’ve had a heavy focus on high-quality, dividend-paying stocks, and I would reiterate that recommendation today.
Consider a company like Wal-Mart (WMT). At current prices, Wal-Mart sports a dividend yield of 2.6%, materially higher than the 2.2% being paid by 10-Year Treasury notes.
But Wal-Mart, unlike the Treasury note, has a long history of increasing its payout every year. In March of 2002, Wal-Mart paid a quarterly dividend of $0.075 per share. In March 2012, ten years later, that same share pays a dividend of $0.398 per share—an increase by a factor of 4. Not a bad run.
A company like Wal-Mart has the power to wring savings out of its supply chain during periods of mild or flat inflation. My recommendation is to build a portfolio of rock-solid dividend-paying machines like Wal-Mart. If I am right about inflation being mild, a conservative dividend-focused portfolio should massively outperform a riskier growth-focused portfolio. But even if I am wrong and inflation ends up being higher than expected, the growth rate of the dividends should guarantee that you outpace inflation and that your standard of living continues to rise.
Disclosures: Sizemore Capital does not currently have a position in any security discussed in this article.
