You Have 3 Choices: Inflation, Deflation, or Stagflation

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There are 3 possible scenarios for the U.S. economy.

Stay alert
Invest accordingly

Deflation

Deflation is the threat dominating headlines. “You’ve got a strong supply of goods and weak demand. That’s a recipe for prolonged deflation,” says A. Gary Shilling, economist and author of Deflation: How to Survive & Thrive in the Coming Wave of Deflation (McGraw-Hill). The problem is deflation’s ripple effect: When banks stop lending, businesses stop expanding and wages fall. Consumers stop spending, which pushes prices lower. Why won’t massive stimulus pull the economy out of the deflationary lane? Shilling fears that the U.S. government’s economic tampering will have a “Big Brother effect,” hurting innovation and permanently curbing growth.

The Signs. The surest sign of deflation is a decline in the consumer price index, which tracks the prices of consumer goods and services. But it’s hard to ignore lower real estate values, which aren’t in the CPI. Home prices fell more than 18% in 2008, according to the S&P/Case-Schiller U.S. National Home Price Index. Another deflation indicator: the higher savings rate, which we’re seeing for the first time in 25 years. Shilling expects the savings rate to rise from 4.2% to 10% in the next decade.

Investment Strategy. “Quality is paramount in deflationary markets,” Shilling says. He thinks most investors should be in short-term certificates of deposit or money-market funds. Those with a 10-year time horizon should also buy tech stocks, such as semiconductors, he says. Companies facing deflation can’t cut prices and must boost productivity through technology.

Inflation

The Argument. Many of the economists and financial advisers polled by BusinessWeek for this story believe the huge amount of money being pumped into banks by the Federal Reserve (chart, right) makes inflation a real threat. Hans Olsen, chief investment officer for JPMorgan Chase (JPM)’s private wealth management business, says the stimulus plan ultimately will lead to higher inflation. However, total inflation is basically nonexistent at -0.4%. The trick is figuring out when it will be a problem. “The nasty thing about inflation is that it’s insidious,” Olsen says. Banishing inflation from the economy once it is “infected” is hard.

The Signs. The leading indicator used to measure inflation is the CPI.

Commodity prices, particularly those of oil and copper, are another bellwether. One indicator Olsen tracks is government debt as a percentage of gross domestic product, which he sees surging from 40% to 80% over the next few years.

Investment Strategy. Mild price inflation is considered healthy for stock investors because it is a sign that the economy is growing. But when inflation spikes, as it did when it hit 13% in the 1970s, interest rates rise and borrowing stops. For bondholders, soaring inflation eats away at asset values over extended periods.

The most direct way to fight this is to buy Treasury Inflation-Protected Securities (TIPS)—government-backed bonds pegged to inflation via the CPI. (TIPS belong in tax-deferred accounts because they are not tax-efficient.) A study by economic consultancy Peter L. Bernstein Inc. found that, for an aggressive investor who is worried about inflation, a 47%/53% proportion of TIPs to stocks (the study tracked broad stock market indexes) provided the best risk-adjusted real returns over a wide range of inflationary environments.

Among mutual funds, advisers favor the Vanguard Inflation-Protected Securities Fund (VIPSX), which had an annualized return of 5% for the past three years. Other plays include the iShares Barclays TIPS Bond exchange-traded fund (TIP) and Pimco Real Return Fund (PRTNX).

Commodities are another classic hedge. A well-diversified commodity play is the Pimco Commodity Real Return Fund (CRIX), which combines commodities with TIPS. Many advisers also like the SPDR Gold Trust ETF (GLD) and the First Eagle Gold Fund.

Stagflation

Stagflation is caused by the combination of slow growth and surging inflation. Slower growth will come from extreme caution by lenders, households, and businesses, while a shortage of production capacity will create inflationary bottlenecks, argues Mohamed El-Erian, chief executive officer at Pimco. “Stagflation will be part of the new normal,” he says.

The Signs. The misery index, which combines the unemployment and inflation rates, is the best gauge of stagflation. In March it was at 8.1%. El-Erian predicts that unemployment will hit 10% by yearend, and 2% inflation could bring the misery index up to 12% by the end of 2010.

Investment Strategy. Insulating your portfolio from stagflation is tough. Equity investors need to take a very conservative stance, focusing on high-quality growth stocks such as Johnson & Johnson (JNJ) and PepsiCo (PEP), says John Boland, financial adviser at Maple Capital Management. Gold, as well as TIPS, will help mitigate some of the inflation risk. El-Erian considers TIPS a bargain because 10-year TIPS are pricing in inflation of less than 1.5% for the next decade, and he sees inflation jumping as high as 6% by 2011.

yahoo-finance Young is a Personal Business editor for BusinessWeek with Tara Kalwarski in New York
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Read Top Fund Managers Comments on Economy

Will the Economy Rise from the Grave?

Will the Economy Rise from the Grave?

morningstar-reports

Mutual fund managers’ quarterly letters, market commentaries, forecasts, and other reports are full of interesting tidbits and, if one looks carefully, investment ideas. Every quarter, mutual funds are required to publish reports, and many portfolio managers, research chiefs, and advisors take the time to express their opinions about the markets, individual stocks, or other items on their minds. Some fund shops publish more frequently–on a monthly or even weekly basis.

Featured Commentary
GMO | Jeremy Grantham | January 2009
Quarterly Letter: Obama and the Teflon Men, and Other Short Stories. Part 1.
…We are deep in the pickle jar, and it seems likely that, in terms of economic pain, 2009 will be the worst year in the lives of the majority of Americans, Brits, and others. Read more…

Tweedy, Browne | Jan. 15, 2009
Shareholder Letter
Unfortunately, there was nowhere to hide in public equity markets in 2008, nor for that matter in virtually any other asset class, as stock markets around the globe collapsed in the face of an unprecedented credit crisis. Needless to say, our funds were not immune to the carnage. Read more…

Recent Commentary
Morgan Stanley | January 15, 2009
Investment Perspectives
Discover Morgan Stanley’s macroeconomic insight and find out what they think of specific regions, industries, and stocks. Click here to read more.

PIMCO | Bill Gross | January 7, 2009
Andrew Mellon vs. Bailout Nation
2008 was the year when the United States led the charge of bailout nations, lending and literally guaranteeing trillions of dollars of private liabilities in an effort to avoid the advent of another Great Depression…Was it necessary and productive to mutate 21st century American-style capitalism into a thinly disguised knock-off of the New Deal? Read more…

PIMCO | Mohamed El-Erian | Jan. 7, 2009
No Immunity From Policy Action
Not long ago, the question of how the actions of national authorities – and the US Federal Reserve in particular – impacted on their investment decisions would get a range of replies from investors. Some observed that their decisions were unaffected; others cited the old mantra that “you should never fight the Fed”. Read more…

BlackRock | Jan. 6, 2009
Outlook & Opportunities in 2009: A Framework for Investing
The financial market turmoil that began in late 2007 has intensified as economic data continue to disappoint and the ongoing credit crisis shows few signs of abating anytime soon. In response, policymakers worldwide have employed aggressive policy reflation measures…Read more…

Royce Funds | Charlie Dreifus | Jan. 6, 2009
Charlie Dreifus Reacts to Being Named Morningstar Domestic-Stock Fund Manager of the Year
I’m very honored to have won. It’s particularly noteworthy that this accolade comes during such a difficult year, a year in which I wasn’t especially pleased with Royce Special Equity Fund’s (RYSEX) performance on an absolute basis. Read more…

Caldwell & Orkin | January 2009
Market Update
Like The Comrades Marathon, the U.S. economy enters 2009 tumbling downhill from a mountain of leverage that it spent 20 years ascending.  This descent has destroyed asset values (real estate, housing and stocks) while, as always, the debt that was used to secure these assets remains steadfastly in place, leaving consumers with tattered balance sheets, negative home equity and stock margin calls. Read more…

ING Clarion Real Estate Securities | January 2009
Market Commentary
Real estate stock investors endure a very tough year. Despite a sizeable rally in December, real estate stocks suffered their worst year ever as equity markets around the world plunged in 2008. Read more…

Legg Mason | January 2009
Month-End Commentary: December 2008
The S&P 500 Index rallied a little over +1% in December, thus allowing 2008 to go into the record books as the worst year since 1937, rather than the worst year since 1931. A small victory, one might argue, but it was a welcome relief to see some “green on the screen” for a change. Read more…

Oak Value Funds | January 2009
Fourth-Quarter Review
There is certainly no doubt that 2008 was a battleground for most investors. The events of the last year challenged numerous fundamental assumptions and theories on investing. Read more…

PIMCO | Paul McCulley | January 2009
Cyclical Outlook
When formulating our outlook, we typically fine tune our GDP and inflation forecasts as a means to anticipate changes in central bank policy. But for now, the standard fine tuning has been put on the shelf because the reality of a recession brings clarity to forecasting. Read more…

T. Rowe Price | January 2009
2009 Investment and Economic Outlook
We are pleased to share the presentations and highlights from some of the firm’s key investment managers regarding the U.S. and markets abroad. Find out Alan Levensons’ outlook for the U.S. economy, Mary Miller’s take on the fixed-income markets, and explore opportunity abroad with Raymond Mills. Click here to see all of the presentations.

WisdomTree Investments | Jeremy Siegel, Wharton professor and Senior Investment Strategy Advisor
Economic and Market Commentary
2009 doesn’t have to be a very good year to be better than 2008. The past year saw equities fall the most since the Great Depression as the global economy slid into recession. But I think that 2009 will surprise on the upside, with both the economy and the markets doing much better than expected. Read more…

Oakmark Investments | Bill Nygren | Dec. 31, 2008
Commentary on the Oakmark and Oakmark Select Funds
There is certainly a camp of investors who believe we are on the verge of a severe depression, and if they are right, zero might be a pretty good relative return. But with that view so widely broadcast, I think the contrary position looks very attractive. Read more…

Investment Outlook – PIMCO

Investment Outlook
Bill Gross | October 2007
What Do They Know?

Under a conservative assumption of 2½% inflation, PIMCO’s view is that the U.S. Fed will lower the Fed Funds rate to 3¾% or so over the next 6-12 months. (Actually that’s only two, 50 basis point reductions from where we are now).  Continue reading