Ryan A. Bailey, CFA, FRM, CAIA, CMT Inflation Ryan A. Bailey, CFA, FRM, CAIA, CMT

Reason for Concern 2

Total 2008 Bailouts = $8.5 Trillion ($3.1 Trillion of which is committed pledges)

Definition of Inflation Inflation – is a rise in the general level of prices of goods and services in an economy over a period of time. "A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money...“ “when more dollars are chasing the same amount of goods” MV = Py M = money suppy; V = velocity (number of times a dollar turns over in a period of time); P = general price level; y = real gdp

Inflation Disasters Hyperinflation – inflation that is very high or "out of control", a condition in which prices increase rapidly as a currency loses its value. Need increase in money supply and an increase in velocity of money Velocity is the average frequency of which a unit of money is spent in a given period of time Stagflation – is an economic condition in which inflation and economic slowdown occur simultaneously Often associated with supply shocks and increasing money supply

Types of Inflation Core Inflation – is a measure of inflation which excludes certain items that face volatile price movements, notably food and energy. What Fed targets – and is intended to be an indicator and predictor of underlying long-term inflation Headline inflation - is a measure of the total inflation within an economy and is affected by areas of the market which may experience sudden inflationary spikes such as food or energy Often the target of foreign central banks, especially in undeveloped world and Europe.

CPI Weightings Food And Beverage 14.9% Housing 42.7% Apparel 3.7% Transportation 17.2% Medical Care 6.3% Recreation 5.6% Education and Communication 6.0% Motor fuel is only 4.3% Does it capture inflation by our definition? Or Can I have inflation And deflation at the same time?

Inflation or Deflation As of 4 November 2009 the federal reserve reported that the U.S. dollar monetary base is $1,999,897,000,000. This is an increase of 142% in 2 years. However Money has not entered economy. M2 which is the broad definition of Money supply has not increased much. Typically it is about 10 times the monetary base and now it is only 5 times Money is not entering the broad economy through credit creation. People can’t get loans , how can they ? They feel poorer and values of assets like homes are down. They have little bargaining power with high unemployment rates to demand wage increases Banks are increasingly more choosy on who they lend to since secondary market for loans is not what it was. Velocity of money is declining and that will offset money creation. Can experience consumer price inflation because commodities will be driven by stronger growth in emerging markets, while consumer prices will lag because of U.S. Macro Problems.

Money supply is increasing, but money in circulation is declining or flat .

Remembering the Goal Goal = Payout + inflation Focus is on how inflation is measured For us it is CPI Thus Goal = 5% + CPI

What Are we Trying to do? Hedge Inflation (Preserve Wealth) or Invest in Inflation (Grow Real Wealth)

Inflation Hedging Short term bonds, TIPS, Commodities, Gold, and Oil are all positively related to inflation. However adding commodities, gold, or oil to a portfolio of stocks and bonds tends to increase rather than decrease the portfolio’s return variance Conclusion – inflation hedge with TIPS and short term bonds and only use the others if you are particularly sensitive to short term inflation If purpose of hedging is to reduce risk, it makes little sense to hedge with assets that are several times more volatile than the risk itself. CPI has a standard deviation of about 4% Disadvantage – whether CPI is a good measure of inflation and methodology could change.

Investing in Inflation Commodity futures – if inflation is unexpectedly high, commodities are likely to be key driver Often trading at a premium to spot and are volatile. Natural Resource Stocks – investing in companies that derive a significant portion of their revenues from commodity extraction and production is a good hedge against future inflation. Advantage- can earn a positive return even if commodity prices are flat or fall modestly Disadvantage – less correlated with inflation than commodities and they trade in sympathy with broad market Private Natural resource investments – Advantage - should be available at more attractive valuations than public companies and will trade more on production and prices. May produce income. Disadvantage – illiquid Gold – Advantage- strong hedge against inflation and economic calamity Disadvantage – no income, only worth what others willing to pay, cost of holding it, source of demand is as a monetary alternative to paper currencies Real Estate – Advantage – inflation hedge in long run, can produce income, great diversifier Disadvantage – may not have much relation to inflation at certain times, and credit conditions can dominate returns, and can become illiquid

Investing in Inflation Foreign currencies – Advantage – liquid Disadvantage – central banks could follow fed and depreciate their currencies to keep their exports competitive. Stocks – Advantage – liquid, and offer protection in the long run. Work great if inflationary environment is being driven by strong global growth. Disadvantage – P/E ratios compress as inflation brings higher rates. Could be out of step for the short to immediate term with inflation

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