A Penny Here, A Penny There

…And Pretty Soon, Inflation Makes You Poorer

Some time last year I argued that when few investments stand out as compelling values there is absolutely nothing wrong with simply owning cash equivalents such as short-term Treasury bills.

In fact, I pointed out that, historically and contrary to popular intuition, times when cash yielded the lowest income have been good periods to hold it. This is because periods of low interest rates usually precede periods of rising rates, which tend to usher declining bond prices, slower economic growth, lower corporate profits and shrinking stock market values – though not necessarily in that order.

That is still my view. However, I feel obligated to stress that, while acceptable as an occasional cyclical posture, the holding of large fixed-income portfolios is not a recommended strategy for long-term estate planning.

The new Chairman of the Federal Reserve, Ben Bernanke, has been an advocate of “inflation targeting”, e.g. of publicly stating the long-term inflation rate that the Federal Reserve would like to achieve with its monetary policy.

Mr. Bernanke goes to great pains to explain that the inflation rate should not be the Fed’s only concern; that defining the ideal rate of price increase is a complex process, involving many considerations; and that no single, rigid formula can be expected to yield the best result for all situations. Still, in a 2003 policy conference at the Federal Reserve Bank of St. Louis, he hinted that, based on his and other studies, the OLIR – the optimal long-run inflation rate – might be around 2%.

Unfortunately, even if the new Fed Chairman is successful in maintaining an average rate of price increase of only 2% per annum, investors soon might be reminded why, in the 1970s, Government bonds were labeled “Certificates of Guaranteed Confiscation”.

As an illustration, let’s assume that you buy today $10 million of twenty-year U.S. Treasury Bonds, currently yielding around 4.5%. (You could improve the yield a bit by buying bonds of an issuer with lower credit, but government paper is still considered the only investment with zero risk of default).

After taxes at 15%, this investment promises you an annual income of $382,500 for the next twenty years – assuming taxes are not raised in the interval. In twenty years, you will also get your $10 million back.

However, what will these figures really mean after twenty years of 2% inflation?

Even at that “slow” rate of price increase, a basket of goods and services costing $100 today will cost almost $149 in twenty years.

Put another way, it means that, the purchasing power of your annual income will have declined from $382,500 to the equivalent of $255,360. As for your capital, when it is returned to you, its purchasing power will have declined from $10,000,000 to the equivalent of $6,676,080.

In other words, after twenty years of 2% inflation, the bondholder will be one-third poorer, in terms of both capital and income.

This is the strongest argument, in my mind, for buying stocks rather than bonds in a long-term portfolio.

In addition, long-term interest rates have now been declining for nearly a quarter of a century, conditioning investors to an environment favorable to bonds that, though long-lived, should not be assumed to be permanent.

Of course, a long trend of declining bond interest rates has also boosted the returns on stocks. The price-earnings ratio of the S&P 500 index rose from as low as 7x in the early 1980s to around 30x only a few years ago and currently stand at around 20x, which is still high by historical standards. That’s my conundrum.

However, in a long-term perspective, stock prices can be expect to receive some support from corporations’ secular sales and profit growth, whereas there exists no such expectation for bond prices. In fact, in the case of corporate bonds, share repurchases or company restructurings may well impair their long-term ability to repay debts.

My conviction has always been that, in a free economy, it is entrepreneurs that create wealth. Those who can’t or won’t be entrepreneurs can participate in this wealth creation process by investing in the stock market. Real estate and perhaps gold may be considered for diversification or “insurance” purpose, but basically, the way to participate in the creation of wealth is to invest with the people who produce goods and services. Everything else (derivatives, synthetic products and countless recent “innovations”) is just noise.

Thus, one may periodically attempt to improve returns (as I am, exceptionally, tempted to do these days) by delaying investment when stock “values” are scarce. Or, one may try to soften the blow of inflation by purchasing inflation-indexed treasuries. But the real foundation of estate planning, for me, remains investment in stocks.

François Sicart

February 24, 2006