Cost of Living

April 14, 2004

Dear Investor:

In the long run we are all dead, said John Maynard Keynes in that most accurate of all economic predictions. But on the way there, most of us have to deal with time’s greatest financial risk: inflation. Like hypertension, inflation is a silent killer: the damage is often slow and hard to measure. In times of relatively low inflation, people focus on anything but. By the time it arrives, it’s often too late.

The huge reflation of the economy is likely to lead to inflation because monetary and fiscal policy tend to overshoot. Everyone knows life is expensive, but it’s likely to get more so. As China shifts from dominant producer to dominant consumer, its global effect mutates from deflationary to inflationary.

How do you protect yourself against this silent killer? There are three good ways: stocks, real estate and inflation-adjusted bonds. Conspicuously absent from this list are commodities, which are misunderstood to be a good long-term hedge against inflation. They are not. They’re a good short-term hedge because commodity prices spike on incipient inflation, as they are doing today, but only for short periods of time. To own commodities as an investor, that is, for a significant amount of years, is unrewarding. To profit from commodities, you must speculate on the short-term, a dangerous game.

The long-term average return on silver from 1871-2000 was approximately 2%, below the average rate of inflation over the same period of time.[1]. In other words, investors in this supposedly precious metal earned a negative real return. Another oft-quoted example is that, in 1904, an ounce of gold bought you a fine suit—and it still does—an example of a zero real return over a century.

In contrast, equity investors earned approximately 10% annually since 1871 and real estate investors 6%, both well above the inflation rate. Since equities and real estate both have tax advantages and the potential for yield that commodities lack, they are doubly preferable. The only commodity hedges worth purchasing are energy companies, which are attractive more for their equity component than for their commodity link: Shell will create more value over time for its owners than any lone barrel of oil.

The most interesting new assets to hedge inflation are TIPS, or Treasury Inflation Protected Securities, which we are adding to accounts where appropriate. TIPS are well-suited to investors facing long retirements who must nevertheless be conservative. TIPS are the only investment we know of that provides anything close to a guaranteed real return above and beyond the inflation rate. Their principal is adjusted upwards in tandem with the CPI.

Although the total return on TIPS is low at the moment, it will increase along with inflation. One disadvantage to TIPS is the potential of deflation, which would render them feeble indeed (although the initial principal level is protected even if deflation adjusts the CPI downward). The other disadvantage is that taxes are due on the imputed income of the inflation adjustment, a problem which can be remedied by holding them in a tax-deferred account. Note that a tax-deferred account, however, renders obsolete one advantage of TIPS: their exemption from state income tax.

The other potential disadvantage to TIPS is the possibility of a significant bubble forming as buyers plow into the market. TIPS funds are raking in record levels of capital, especially in the wake of Bill Gross’s highly-publicized purchases at PIMCo, which has pushed their yields unsustainably low. When a buyer like Gross is willing to announce his entry, it often means that the best days are over. So it pays to keep a close eye on the TIPS market. In the long run we may all be dead, but we still may wish to take our time getting there.

[1]Handy & Harmon Silver Spot Price as quoted by Morgan Stanley Dean Witter