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Some Thoughts On Inflation

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A few weeks ago, we had breakfast with an institutional portfolio manager at Franklin Templeton. We talked about a number of things but we always like to ask these people about the most common questions they are asked. This way we get a feel for the concerns of others in our industry. In this case, the answer was simple: “interest rates.”

Ever since the Fed announced the first quantitative easing (QE) program a few days before Thanksgiving 2008, we’ve seen endless speculation about when, and how all that money creation would lead to inflation and higher interest rates. Five years later, we continue to speculate about it.

Nobody knows when rates will go up or by how much and we wouldn’t pay much attention to anyone who says they do. The nice thing about the current situation is that we do have the convenience of knowing that rates will probably go up rather than down because rates are basically zero now and a negative interest rate environment is close to impossible to sustain. After all, would you pay the bank to deposit money in your own account?

We should also note that the Fed can directly affect short term rates but its ability to do anything with longer rates like the 30 year bond (upon which many mortgage rates are based) is limited. Longer term rates tend to be set by supply and demand in the market.

Inflation and interest rates tend to move together but we need to be careful about which kind of inflation we are looking at.

The price of commodities is often influenced more by supply and demand but many people tend to misinterpret the increase in the price of a commodity such as oil, as an increase in overall inflation.

The thing that worries many people is monetary inflation and what happens when more US Dollars find their way into circulation and start driving up prices of everything. Some inflation can be good for an economy because it encourages everyone to continue to be productive but if prices soar too high too quickly, it can have a detrimental effect on an economy and drive down the value of its currency.

Interest rate increases tend to follow inflation as either the market tries to keep up with rising prices or the government tries to cool down the economy with higher short term rates.

So, given all this, what do we look at as an indication of future inflation? In our opinion, the thing to keep an eye on is wage inflation resulting from a lower unemployment rate and higher wages. The other thing to look at is hiring by small business since this is where jobs are created in our economy. So far, this isn’t happening. Unemployment has been gradually falling but we have also seen many people leaving the workforce which cushions that rate somewhat.

The bottom line, in our opinion, is that we probably won’t see much monetary inflation until we see all or at least some of these statistics improving. Until then, our investment strategy will be to regard this as a low inflation, low interest rate economy and this will be reflected in our portfolio management considerations. At some point in the future, there will probably be a time to overweight investments like inflation adjusted bonds and commodities but we do not think that time is upon us yet.

As we finish up the first quarter of 2014 it has become obvious that 2014 is a very different year than 2013. Last year started with a bang and never really looked back. This year, we’ve seen quite a bit of rotation into different sectors but overall movement has, at least so far, been sideways.

2013 was a great year for stocks but in our opinion, the only way to “beat the market” was simple and incredibly dangerous. It meant no diversification and no hedges.

Since many people only focus on the S&P 500 Index or the Dow Jones Industrial Average, we’ve heard a lot of noise about how many professional managers didn’t beat the market. It’s very easy for people who do not owe a fiduciary responsibility to anyone to make comments like this in hindsight. We have to make investment decisions today and must do so without this luxury.

One of the most important strategies we use is diversification. We don’t only invest in US stocks or bonds. We look at international equities and bonds along with additional asset classes like real estate, metals, commodities, and absolute return strategies.

The thing about a well diversified and properly constructed portfolio is that it should have less volatility and a more stable return over time. It’s not something that works all the time but we prefer it to the option of chasing last year’s favorite mutual fund or sector.

Unfortunately, a diversified portfolio is always going to have something wrong with it. There will always be something lagging because we will never know the best asset classes until after they have had their day.

We are entirely unrepentant about this. After 20+ years each in this business, we know what works for us. Our goal is to avoid a permanent impairment of capital and we feel a diversified portfolio has a better chance of giving us less volatile results. It will probably never be the highest return in any given year but if we investors have less volatility in our portfolios, we are less likely to buy or sell at the wrong time.

The Takeaways:

• We will continue to see a lot of speculation about interest rate movements but we’ll be surprised to see anything major until we start to see wage inflation pick up.

• 2014 has basically been a sideways market so far. We view this as a productive pause and continue to feel that a well-diversified portfolio is the better long-term strategy for many investors.

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