A U.S. economist is challenging the widely held notion that inflation is low and there is little need to inflation-proof an investment portfolio.
The points he raises are serious enough that investors should reconsider how their portfolios are structured and whether a sizeable position in precious metals is warranted.
First, consumer inflation is not really at the officially reported level of around 2 per cent, says David Ranson, President and Head of Research of U.S.-based H.C. Wainwright and Co. Economics Inc. (www.wainwrighteconomics.com).
Rather than relying on the government’s consumer price index (CPI), he has constructed a more realistic index of consumer inflation that is based exclusively on market prices. This new index is showing an actual inflation rate of around 8 per cent in the United States.
The difference is mainly in how the price of housing is taken into account. Ranson’s consumer inflation index incorporates the market price of new and used homes. However, in the official CPI, housing costs are based on the imputed cost of renting a home.
Given the escalation in new home prices versus rents in recent years, the discrepancy is large and it gives credibility to the view that official statistics in both Canada and the United States are under-reporting the actual price inflation that people are facing.
Another element of the official CPI is that it measures a same-quality basket of goods and services, which, due to quality enhancing technological changes for many products, means that prices are actually adjusted downward in many cases when they are included in the official index.
A research report commissioned recently by The Daily Telegraph, a British newspaper, showed a similar statistics problem where the rate of increase in the cost of living for many U.K. households is up to four times the government’s published CPI rate of inflation.
The second main point that Ranson recently made at a Toronto briefing organized by Bullion Management Services (www.bmsinc.ca), managers of the Millennium Bullion Fund, is that the trend in precious metals prices (gold, silver and platinum) is “the best leading indicator” of future consumer inflation.
“According to these and other market data, current inflation is much higher than policymakers realize and is still accelerating.”
This is a harsh conclusion for any investor with a traditional portfolio of stocks and bonds. Inflation, he concludes, is going to get worse and “inflation weakens the economy and that is bad for stocks. Bonds also underperform in an inflationary environment.”
Ranson points out that investors may think they are getting a good return in dollar terms from their portfolio but “returns in an inflationary climate are partly illusory.”
This brings us to Ranson’s third main point: Precious metals historically have preserved actual purchasing power over time and investors need more than the 5-per-cent allocation in precious metals that investment professionals advocate as an “insurance policy” for a portfolio.
His historical analysis suggests that in an inflationary environment, a precious-metals allocation of 32 per cent would be required to minimize the effects of inflation over the long term in a typical portfolio that consists of 60-per-cent stocks and 40-per-cent bonds. If you want to get ahead of inflation, the allocation should even be higher. And for an all-bond portfolio, the allocation needs to be at least 18 per cent, he says.
Ranson’s points are unorthodox but they are hard to dismiss. Many of us in North America are experiencing an actual inflation rate that we know is higher than the official rate. It may not be as high as 8 per cent but it is higher than 2 per cent.
We have also seen precious metals prices escalate (gold rising from $275 (U.S.) to more than $600 per ounce in five years). In reality, inflation (a loss of purchasing power) has been occurring all around us, as property values and commodity prices have escalated quite rapidly.
We also know that central-bank policy is to ensure some inflation every year (why else a target of 1-to-3-percent official inflation in Canada?), so inflation is not going to stop anytime soon and it will continue to erode the purchasing power of paper money.
Is your portfolio set up for this?
Wayne Cheveldayoff is a former investment advisor and professional financial planner. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.
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©2006 Wayne Cheveldayoff