Protecting Purchasing Power during Inflationary and Deflationary Environments
Inflationary and deflationary environments are monetary phenomena that can lead to disruption in rational economics. The often self-reinforcing effects can be devastating to retained wealth as well as real earnings and purchasing power.
As we manage portfolios for our families, one of our primary objectives is to manage risk in order to limit downside losses in difficult markets. By doing so, we are able to compound capital at a higher starting dollar amount when favorable financial markets return. In our constant pursuit of protecting capital and preparing for numerous possible outcomes, it is important to address the possibility of an abnormal inflationary or deflationary environment.
The purpose of this white paper is to explain the components and effects of inflation and deflation while touching on the most effective investment strategies for an inflationary environment (precious metals, hard assets, Treasury bills) and a deflationary environment (liquid currency and long-duration bonds).
INFLATION - A MONETARY PHENOMENON
Inflation is generally defined as a rise in the general level of prices of goods and services over a period of time. Economic theory describes inflation as an excess supply of money and credit purchasing a scarcity of goods, resulting in price increases. Thus, the recipe for inflation is aggregate money supply growth in excess of Real Gross Domestic Product (“GDP”) output coupled with an increased frequency of purchasing goods and services (i.e., an increased velocity of money). Scarcity of goods can also create an emotional response such as hoarding.
The government has two ways it can increase the money supply: (1) it can create currency, or (2) it can issue and monetize debt. Monetizing debt is a two-step process by which the government issues debt (i.e., T-bills, notes, bonds, etc.) to the public in return for an inflow of money. When a government needs more money than creditors are able or willing to lend at a reasonable price, it turns to the central bank. The central bank can purchase the debt from the public and the public is left with an increased supply of money. The creation of money in the banking system generally will not result in inflationary effects until the money is ready to be spent. Thus, the transition between money supply growth and physical inflation does not usually manifest until the velocity of money increases which represents the ‘chasing of goods and services’ component For example, the 2009 financial recovery in the U.S. and scarcity of goods and increase in money supply pre and post COVID-19.
THE EFFECTS OF INFLATION
The Consumer Price Index (“CPI”) is an inflationary indicator that measures the change in the cost of a basket of products and services and seeks to measure the cost of living. Between 1947-2024, the value of $1 USD lost over 90 percent of its value, now worth roughly $0.06 in terms of real purchasing power.
How is this affecting real spending power?
As an inflationary environment causes the cost of goods and services to increase, the amount of money needed to maintain a constant lifestyle goes up. In real terms, this represents a deterioration of retained wealth and savings and requires an adequate investment return to maintain real constant wealth.
THE INFLATION EFFECT
Inflation adversely affects the ability to maintain a constant spending lifestyle. Runaway inflation causes prices on goods and services to become quickly revalued and disrupted which, historically, has placed a premium on such real, tangible assets as precious metals, commodities, property, and equipment. Conversely, financial assets such as equities and long-term bonds perform poorly. Businesses must also contend with supply chain issues, shortages and an increasingly strained consumer.
Precious Metals: An Effective Hedge
In an environment of inflationary expectations, precious metals such as gold and silver can provide exceptional hedges. From the increasing inflation environment from 1973-1980 and again from 2000-2011, precious metals formed a price bubble as the price of gold and silver increased drastically amidst investor demand.
Commodities: Short-Term Increase, Uncertain Long-Term
Over the short term, commodities are among the best-performing asset classes as businesses and consumers increase commodity purchases in anticipation of future price increases. However, the long-term effects of inflation cause prices to fall gradually over time. After about two years, commodity prices begin to decline as a result of a decrease in purchasing power and rising real interest rates. As interest rates and commodity prices tend to be inversely correlated, this most often lowers commodity prices.
Cash Alternatives: Liquidity For Future Development
Cash alternative returns increase in response to the expectation of inflation, but the response is gradual. While the value of money declines, a liquidity premium is placed on the ability to quickly purchase goods and services. In addition, the low duration of money markets and short-term T-bills allow for the capture of rising interest yields as key rates rise to coincide with inflation. There is one caveat: cash returns are, to a large extent, determined by monetary policy and the real interest rate targeted by policymakers.
Bonds: Sensitive to Inflation
Nominal bonds are affected by inflationary pressure for two reasons. First, the increase of interest rates on bonds has an inverse effect on the nominal bond price (bond duration determines the severity of the price depreciation). Second, the bond coupon and principle become less on a real basis as the purchasing power of the coupon diminishes with time in an inflationary environment.
Long-duration corporate and treasury bonds have been among the worst-performing asset classes as inflation expectations rise. Over the long term, however, returns begin to be dominated by higher running yields rather than price declines. Inflationary expectations are likely to lead to higher yields on newly issued bonds which can increase the total return of bonds in a laddered portfolio.
Equities: Experience Initial Gains, Followed by Deteriorating Financials
In an environment of monetary inflation, equities can experience a short-term run-up in price as the increase in money supply channels additional funds to equity markets. However, this short-term effect is not lasting as the nominal increase in equity prices is not sustained by real output of earnings in the long run. Similarly, price to earnings (P/E) ratios have historically decreased in inflationary environments according to analysis of the P/E of the S&P 500 coupled with inflationary periods. In inflationary times, P/E ratios have often been less than 10. With the S&P P/E currently at around 27 this translates to a possible drop in equities prices.
At the aggregate level and over the long run, the company can pass through inflation in the form of higher prices. However, this becomes burdensome on profits as the company must be an intermediary for passing on price inflation of goods and labor. These factors can have a deteriorating effect on earnings as companies effectively subsidize price appreciation in the value chain while consumers must contend with less spending power.
In addition, an environment of runaway inflation can cause companies to act hastily with cash and earnings reserves which have, in the past, led to a capital spending bubble. As companies look to convert cash into tangible value, they increase commodities, inventory, and equipment spending which often leads to oversupply and/or imprudent purchases.
Real Estate: An Imperfect Hedge
Because real estate is backed by land and real assets, it can provide a hedge against inflation. However, due to the historical lag in the property market’s response to inflation and the often poor price discovery that results from the illiquid nature of the real estate market, real estate has downside in hedging against inflation. It is also necessary to consider the rising cost of ownership, including interest, maintenance, insurance, and property taxes. On the residential side, taxes can be confiscatory as retirees struggle for cash flow even though the home price is up.
While commercial real estate is backed by real assets as well, it has a greater co-dependence on economic factors and many of the characteristics of equities. The nature of income-producing property is that the cash flow is dependent upon occupancy. Logically, occupancy can be adversely affected by unemployment, bankruptcy, and reduced tenant output. During the 1972-1983 inflationary bubble, commercial real estate exhibited a volatile relationship with inflation. Post-Covid, many businesses and employees have transitioned to a higher degree of remote work environments which is causing less demand for office and commercial space in some areas.
ASSET CLASSES AND DEFLATION
Deflation generally occurs as a result of too few dollars and credit chasing a surplus of goods. The surplus of goods and the deficiency of funds leads to a decrease in aggregate demand and an overall price decline. Deflation generally occurs when a financial system has too much leverage and moves to reduce it—resulting in asset deflation as seen in 2001-2002 and 2008-2009. The psychological effect of a perpetual decline in asset prices causes consumers to put off buying today what they could buy tomorrow. This decrease in consumption has a negative impact on the economy. It becomes increasingly difficult for businesses to sell products and services, which results in decreased earnings, restructuring, bankruptcy and increased unemployment.
Unemployment and lack of business growth creates a negative feedback loop as unemployment further reduces aggregate demand and spending, thus creating a shrinking business cycle. The deflationary outcomes that followed the Great Depression and the post-1990 Japan-era manifested into an economic catastrophe as asset class prices stagnated or dropped significantly. The often forced liquidations to meet obligations created ripple effects in credit resulting in further defaults. This type of environment causes a “bunker” effect in which capital is allocated into whatever assets are perceived to preserve wealth. Only two assets have proved to protect an investor during deflation: longer-term government bonds and cash equivalents.
Bonds: Maintain Purchasing Power
Bonds have been among the best performers in a deflationary environment as coupon payments increase in real terms of purchasing power. Bonds also pay out at par at maturity, thus sheltering the nominal value of the bond from real price decline. Long-term treasury bonds have been among the best asset class as credit risk and long duration provide sustained cash flow and interest payments. Long-term corporate bonds of questionable credit quality can become hazardous as bankruptcies generally rise, thereby increasing the default risk of bonds.
Gold: A Store of Wealth or “Bunker Asset”
Gold has been considered an effective deflation hedge as it protects wealth in times of economic crisis as investors begin to question the value and solvency of paper-based assets and financial instruments. While the value of most intangible and real assets can be in a state of decline, gold acts as a “bunker asset” as it has no counterparty and can shield against financial panic and economic instability.
Real Assets: Lack of Demand Leads to Price Declines
Real asset prices fall in deflationary environments as both personal and business consumption decline. Real asset deflation begins as there are fewer buyers than the supply of goods, creating an aggregate price decline. The deflationary cycle continues as those who do have funds to buy goods delay purchases in anticipation of future price decline. In addition, assets owned through debt, can suffer extended losses as businesses and investors are forced to liquidate assets to satisfy debt payments in the face of decreased liquidity.
Equities: Experience Significant Losses
Equities have historically performed very poorly in deflationary environments as falling aggregate demand for products and services causes a reduction in earnings and often forces restructuring and bankruptcy. In the past 100 years, most observed periods of deflation were coupled with the S&P 500 P/E ratios being less than 10. With the S&P P/E currently at around 27, this translates to a possible drop in equities prices.
IN CONCLUSION
The global economies and markets saw drastic changes between 2020-2024. A rapid and sudden deflationary market followed by a large increase in money supply and government stimulus led to large price swings in most assets. At the same time, prices of many goods and services experienced a rapid deflation followed by gradual inflation over the past several years. The economic shutdowns in response to COVID caused a change in global supply chains resulting in scarcity of goods ranging from semi-conductor shortages to hoarding of toilet paper. Rapid price changes can often result in irrational behavior and uneconomic decisions that can be both a risk and an opportunity for the rational minded. With the potential for further price movements on both asset prices and CPI, we feel it is important to develop an understanding and plan for the potential of further inflationary or deflationary outcomes.
While we cannot control inflation or deflation, we can help position our families’ portfolios to achieve our ultimate objective of protecting and growing capital and ensuring that our clients are able to maintain a constant lifestyle. To accomplish this goal, we believe it is important to balance the short-term and long-term horizon by employing investment strategies that give our families the best chance of success amongst many types of economic environments.
QUESTIONS?
Please do not hesitate to reach out to our team.
We look forward to hearing from you!
Data provided herein is for informational purposes and not a recommendation to buy or sell securities, nor should the information be relied upon for any individual asset class or investment decisions. Cayside Partners, LLC is a Registered Investment Advisor registered with the Securities and Exchange Commission and subject to the State of Florida’s regulatory oversight.
This document is not intended as an advice, an offer or solicitation with respect to the purchase or sale of securities. Neither the information nor any opinion expressed in this document constitutes an offer, an invitation to offer, solicitation or a recommendation to enter into any transaction. The information in this document does not purport to be all inclusive or to contain all of the information that a recipient may deem material to its decision to invest. Any summaries of documents should not be relied on and references should be made to the full document. The information contained in this document is subject to change. Nothing in this document constitutes accounting, legal, regulatory, tax, financial or other advice. Recipients should form their own assessment and take independent professional advice on the suitability and merits of investment and the legal, regulatory, tax and investment consequences and risks of doing so.
Cayside Partners (“Cayside”) accepts no responsibility to any person for the consequences of any person placing reliance on the content of this information for any purpose. The information contained in this document, including any data, projections and underlying assumptions, are based upon certain assumptions, management forecasts and analysis of information available as at the date hereof and reflects prevailing conditions and Cayside’s views as of the date of the document, all of which are accordingly subject to change at any time without notice, and Cayside is under no obligation to notify you of any of these changes. In preparing this document, Cayside has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which has been otherwise obtained and reviewed by Cayside in preparing this document. While the information provided herein is believed to be reliable, Cayside makes no representation or warranty whether express or implied, and accepts no responsibility for, its completeness or accuracy or reliability. Cayside shall not be liable for any loss or damage, whether direct, indirect or consequential suffered by any person as a result of any errors in or omissions from the document (or other information) or as a result of relying on any statement contained in this document (or other information). Past performance information contained in this document is not an indication of future performance. Where projections, forecasts, targeted or illustrative returns or related statements or expressions of opinion are given (“Forward Looking Information”) they should not be regarded by any recipient of this document as a guarantee, prediction or definitive statement of fact or probability. Actual events and circumstances are difficult or impossible to predict and will differ from assumptions. A number of factors, in addition to any risk factors stated in this document, could cause actual results to differ materially from those in any forward-looking Information.
Being general advice, the information material in this document has been prepared without taking into account any investor’s investment objectives, financial situation or particular needs. Before acting on this general advice, the investor should consider the appropriateness of the advice having regard to their own situation. Cayside recommends the investor obtain financial, legal and taxation advice before making any financial investment decision.