Riding out the tides of inflation, deflation

Advisers often speak about the risks of inflationary or deflationary conditions and their effects on investment opportunities.

While we know intuitively what inflation versus deflation means to our clients, how much do we really know about how they work and what they mean to clients’ portfolios?

At a basic level, inflation and deflation are two sides of the same coin that have divergent effects on consumer and corporate behavior.

Inflation influences investors to make purchases today because prices tomorrow will be higher.

Deflation, by contrast, encourages one to postpone purchases, as the price tomorrow will likely be lower.

To understand how the government can attempt to control both inflation and deflation, we need to understand that throughout history, we have had two types of currencies, representative and fiat.

Representative currency is backed by a physical commodity such as gold or silver and is redeemable for the physical commodity. A designated amount of the commodity is required prior to issuing a gold or silver certificate.

Fiat currency is backed by the full faith and credit of the sovereign nation issuing the currency. The only materials required to create fiat currency are paper, ink and a printing press.

Inflation in a fiat currency economy is controlled through monetary and fiscal policy. The dual levers of monetary and fiscal policy regulate an economy by adjusting the money supply, interest rates, taxes and government spending.

Deflation is much more difficult for governments to control, as the tools to remedy the situation remain limited. Industrialized and emerging nations are printing money at the fastest pace in two decades. The intended goal of this policy is to eliminate the risk of deflation and to foster controlled inflation.

Today our central bank is promoting an expansionary monetary policy by increasing the money supply and lowering key interest rates. In addition, the incoming Obama administration has indicated that it will increase spending by investing in the country’s deteriorating infrastructure — and has backed away from its campaign promise to raise taxes.

We believe that the government will succeed in its endeavor but will overshoot and create an inflationary problem 12 months to 24 months in the future. The best way for investors to take advantage of this is to position their portfolios with inflation-sensitive investments that will benefit from a decline of the real value of our currency.

COMMODITY STRATEGIES

Commodities offer a hedge against inflation as fiat currency undergoes a decline in real value. Investors should focus on commodities that require long periods from discovery to production, such as copper, which takes between seven and 14 years.

In addition, investors who focus on hydrocarbons or metals should benefit from increased demand from emerging markets that have an embryonic middle class.

Ac-cording to a 2003 study by The Goldman Sachs Group Inc. of New York, commodities saturation in a growing or emerging economy occurs at an inflation-adjusted $6,000 of per capita income.

For example, China’s gross domestic product was at $2,000 per capita at the end of 2007, and it is not estimated to reach the crossover threshold until sometime between 2018 and 2020. India is not going to reach saturation for another 25 years. Therefore, the demand for industrial commodities should remain in a secular bull market with minor cyclical contractions for at least the next decade.

On the other hand, agricultural commodities such as corn or soybeans are rotated every season, so a supply shortage one year can be offset by oversupply the next, making the sector a poor long-term investment.

So what does all of this mean to the wealth manager trying to explain this to clients or trying to make decisions on their behalf?

Helping our clients understand economic policies, especially as an administration begins, will make us confident money managers during these difficult times.

Investors are scared and worried about what will happen next. The reality is that we will have more difficult times. Knowledge and confidence about what is happening — and what it all means — will differentiate one wealth manager from another.

Shakeel Dewji is the president and chief investment officer of Aurora Investment Managers LLC of Norwood, Mass.

For archived columns, go to investmentnews.com/investmentstrategies.