Issue 31 • JULY 1, 2009

Deflation Now ...
Inflation Later?

In Econ. 101 class, I was taught that the Federal Reserve’s mandate is to promote low inflation and economic growth. In the real world, however, the temptation to inflate away growing debt has often proven too difficult for central banks to resist.

As I explained in last week’s Weiss Advice, the temptation ... and political pressure ... is growing on the Fed to let its printing presses run wild in the years to come. We have a fast-growing list of government-sponsored (and taxpayer funded) bailouts for: the financial sector ... housing sector ... auto makers ... the energy sector ... and coming soon to health care too.

About HALF of the U.S. economy is now hooked up to some form of government life support. The long-run consequences of this massive spending is likely to be higher deficits, financed with more government bonds at higher interest rates, as I discussed in another recent article.

But just when will these long-run consequences come home to roost? Timing this next financial storm is the tricky part. The fact is that right now, lingering deflationary pressures still seem to have the upper hand, not just here in the U.S., but around the world too.

Every week at Weiss, our Investment Committee meets with our team of financial advisors to discuss our outlook for financial markets and the economy, including our views on inflation. I really enjoy these meetings, in particular because of the unique feedback we get from our advisors, based on the conversations they’re having with our clients and prospective clients.

It’s refreshing to hear their points of view, because it’s the best way to find out what’s foremost on investors’ minds right now. With that in mind, I’m turning over this week’s Weiss Advice column to Jeff Kaufmann, one of our Weiss Financial Advisors.

Recently, Jeff and I talked about the questions he’s been getting lately about our outlook on deflation versus inflation ... and about a few investment ideas to consider for today’s market. I’ve asked Jeff to share these insights with you ... in his own words ... so, take it away Jeff!

The Inflation/Deflation Debate That’s on Everyone’s Radar Screen Right Now

Last year, American’s experienced the lowest rate of inflation since 1954, with consumer prices actually declining -0.7% year-over-year in December 2008. This is the textbook definition of deflation: a general and persistent fall in prices for many goods and services at the same time.¹

This bout of deflation—the first ever experienced in the post World War II era— is, of course, due to the epic decline in our economy, which we have written about frequently in Weiss Advice. The Federal Reserve is attempting to arrest the free-fall in our economy with massive interest rate cuts and other liquidity measures, as Mike noted.

So, it certainly appears that the Fed is planting the seeds now for a resurgence of inflation later ... but how long before these seeds take root and sprout into full-blown inflation ... as we witnessed in the 1970s?

There are already signs that last year’s severe bout of deflation is starting to ease, considering the recent rise in oil and other commodities, not to mention the stock market.

Also, even though falling prices are the trend in many industries, not all costs are dropping across the board. Health care costs to employers, for instance, actually rose nearly +10% last year, and are expected to rise another +9% next year too, even amid the worst recession in decades.²

In recent times, Japan went through a great asset bubble in real estate and stock prices, similar in some ways to what the U.S. has just experienced. After Japan’s bubble burst in 1989, its economy suffered periodic bouts of deflation on a recurring basis over the last 20 years (See chart above). In the U.S., the inflation rate, which just went negative last year for the first time in decades, could follow a similar pattern of trending above and below the ZERO line in the years ahead.³

It still seems likely that exploding deficits and a massive increase in the money supply will lead to inflation eventually, but we may be seeing mixed messages for some time in the deflation/inflation data debate.

One Way to Potentially Shield Your
Buying Power from Eventual Inflation

The United States Treasury offers a special kind of security, called a Treasury Inflation-Protected Security (TIPS), whose principal amount is adjusted for inflation. The Treasury Department issues TIPS because it believes their issuance will reduce interest costs to the Treasury over the long term and attract different types of investors than those who traditionally buy government debt.⁴

TIPS offer a number of potential benefits for investors. First, like all Treasury debt, TIPS are direct obligations that are backed by the full faith and credit of the United States government. That pledge may not be worth quite as much as it once was, but for now, U.S. Treasuries are still considered the gold standard among government bonds.⁵

A second big advantage that’s unique to TIPS is that your principal should be protected against inflation. That’s because the principal value of TIPS is indexed to the Consumer Price Index (CPI) and grows over time with the CPI inflation rate.⁶

Investors in TIPS should expect that the real purchasing power of their principal will keep pace with inflation. But keep in mind that in a deflationary climate, the principal value of TIPS may also decline.

At maturity however, the Treasury will pay an amount that is no less than the par (face) value on the date the security was first issued. That’s why it’s important when buying TIPS, as with any bonds, to carefully consider any premium over par that you are paying, balanced against the number of years left until maturity.

Unlike typical Treasury bonds, the interest income received on TIPS is also adjusted for inflation. Investors receive interest payments every six months based on a fixed interest rate that’s applied to the inflation-adjusted principal. In this way, investors should see an increase in the real rate of interest above inflation.⁷

How to Prepare for Inflation Later ...

As we discussed, inflation is lower now than at any time in decades, but many folks are still rightly concerned that their investments, including Treasury bonds, may lose purchasing power over the long run.

At Weiss Capital Management, we understand the prospects for inflation, and we are preparing the portfolios we manage now, where appropriate. For instance, our Managed Treasury Program currently holds TIPS as a hedge against the eventual return of inflation. This strategy is also opportunistic in purchasing longer term Treasury securities, such as TIPS, with the goal of earning short- to mid-term capital gains from big swings in Treasury bond prices.

Also, our Diversified Income Builder and Weiss Balanced Program strategies currently hold mutual funds that invest in TIPS to offset rising interest rates and as an inflation hedge. Our new All Weather Managed Account strategy holds a position in TIPS as well right now, for portfolio diversification and as an important hedge against the likelihood of inflation down the road.

To find out more about TIPS, and how they might fit into your own investment portfolio, contact any of our Weiss Financial Advisors by calling 1.800.814.3045.

Sincerely,
Jeff Kaufmann
Financial Advisor
Weiss Capital Management, Inc.

¹ Bloomberg: U.S. Economy: CPI, Industrial Production Tumble, 1/16/09
² Business Week: Survey: Company Health-Care Costs to Rise 9% in 2010, 6/18/09
³ Financial Times: Tackling inflation, 12/4/08
⁴ The Securities Industry and Financial Markets Association: InvestinginBonds.com, 6/27/09
⁵ Ibid
⁶ Ibid
⁷ Ibid