The Inflation, Debt Connection

6/4/2012


$561,254 per household.

That amount would cover the federal debt and retiree commitments, according to a USA Today analysis.

The report states that while the "official" deficit in 2011 was $1.3 trillion, that number more than triples to approximately $5 trillion when retiree benefits are included. To put that amount in perspective, the government's "red ink" in 2011 equaled $42,054 per household, or nearly all of the income of the typical household.

Debt has become a lightning rod for debate inside and outside Washington. Should taxes rise or fall? Where and how much should the government cut spending?

The lack of consensus — and seemingly intractable positions on both sides of the aisle — have led many observers to believe that inflating our way out of debt is the political path of least resistance. After all, inflation is a debtor's best friend; it reduces the value of the debt. And the U.S. has an option that debt-strapped countries like Greece or Spain do not — printing its own currency.

Running the printing presses has consequences, however, including the possibility of runaway inflation. Inflation represents too many dollars chasing too few goods and services. Prices rise, and the purchasing power of a dollar erodes.

All investors should care about inflation. Here's why:

• Higher inflation is often accompanied by higher interest rates. That's bad news for bonds, which usually falls when interest rates increase. For example, a 1% rise in interest rates would knock down the value of the Vanguard Total Bond Market Fund ($11; VBMFX) by roughly 5%; a 2% rise in interest rates, around 10%.

• Rapidly rising prices, especially on raw materials, boost operating costs. And if companies lack pricing power, those higher costs erode profits, which in turn erodes stock prices.

• Stocks are valued based on the present value of future cash flows. If high inflation causes tomorrow's corporate cash flows to be discounted at a higher rate relative to today's dollars, stock valuations compress. In a nutshell, higher inflation means lower price/earnings ratios, which usually means lower stock prices.

Of course, what matters to the markets is not where inflation has been, but where it is heading. Many believe inflation will inevitably skyrocket, given the trillions of dollars in federal debt. While such fears are well-founded, we see some dampers that should limit prices' urge to surge in the near term. One brake on inflation is wage growth. Wage growth has been tepid over the last three years, averaging about 1.6%. Given the slack in the labor market, the Forecasts does not foresee wage inflation igniting a bigger inflationary spiral for at least the next 12 to 24 months.

If you are especially concerned about inflation, tilt the equity side of your portfolio toward commodity-oriented stocks, such as energy giants Exxon Mobil ($82; XOM) and Chevron ($100; CVX). Such stocks tend to demonstrate above-average resiliency during inflationary periods.

In addition, companies with rapidly growing dividend streams — for example, Intel ($26; INTC) has boosted its dividend three times in the last 18 months — represent decent inflation hedges. Exxon Mobil and Chevron and rated Buy and Long-Term Buy. Intel is a Focus List Buy and a Long-Term Buy.


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