I believe the single greatest threat to investors over the next five to ten years is the “loss of buying power or loss of purchasing power” from inflation, which is another way of saying the U.S. dollar, is losing value.
From 1978 to 1981, our country suffered through approximately 17% inflation compounded over those four years. That means that if you had $1.00 in late 1977, it was only worth about $0.32 in purchasing power in early 1982.
That loss of buying power for retirees over those four years was devastating and many never recovered from that loss. For an historical comparison, $1.00 in 1903 is now worth about $0.03 in buying power today.
Historically, during times of global turmoil investors have usually invested their money in U.S. dollars, which was viewed as the safest and most stable currency in the world.
But that’s not happening today, even with all the tumultuous events this year. With the Middle East in conflict, a war in Libya, an earthquake, tsunami and nuclear plant meltdown in Japan and Europe facing a debt crisis in Portugal, the dollar has been gradually falling in value against other major currencies.
It has fallen relative to the Euro, Pound, and Yen in recent months, and currently, the dollar is down 7% against a basket of six major currencies since January 7 and 14% since June.
WHO WINS & WHO LOSES FROM A WEAK U.S. DOLLAR?
In the short run, a cheaper dollar benefits companies that ex-port—and the workers they employ—are more competitive. But the drop in the dollar also makes it more expensive to buy a gallon of gasoline, a foreign-made television or a European vacation.
INFLATION IS JUST BEGINNING A LONG RUN!
Many analysts believe we are in the beginning stages of a multi-year trend of higher and higher inflation. And for investors, the word inflation is just another way of expressing the loss of the purchasing power of the dollars they hold in their investment portfolio.
Last week in USA TODAY, Warren Buffett, the chairman of Berkshire Hathaway, and America’s greatest investor was quoted as saying, “If you ask me if the U.S. dollar is going to hold its purchasing power fully at the level of 2011, five years, 10 years or 20 years from now, I would tell you it will not.”
American bond manager, Bill Gross of PIMCO, stated recently in his company’s newsletter that since the late 1990’s, the U.S. dollar has declined by 30% against a basket of major currencies. He also believes that inflation is higher than the government calculates and that this dollar depreciation should sap the purchasing power of U.S. consumers, as well as potentially raise the global valuation of dollar denominated assets like oil and gold.
He said America was unique amongst almost all nations in that we rarely see the negative impact of our currency depreciation. Unless we experience the sticker shock of a foreign hotel room or meal during a European vacation, we are oblivious to the drop in the dollar.
If the stock market were to go up 10 percent in a year in dollar denominated terms we would assume we are 10 percent richer, even if the dollar is sinking in value at the same time.
If the cost of imported goods and especially gasoline goes up more than our paychecks, we would blame it on political conspiracy.
The fact is that annual budget deficits in the trillions of dollars add a like amount to the stock of outstanding dollars, resulting in currency depreciation, higher import inflation, and a degradation of dollar based assets in global financial markets. We would become less, not more wealthy.
He believes that long-term holders of U.S. Treasury bonds could lose actual principal as the Federal Reserve eventually starts to raise rates over the next few years. He warns U.S. Treasury bond holders to sell their longer-term bonds.
Billionaire investor Warren Buffett also warned last week in USA TODAY that “investors should avoid long-term fixed income bets in U.S. dollars because the currency’s purchasing power will decline.”
There is a myth in the United States that China owns most of our U.S. treasury debt. That is not true! China only owns about 7.5% of the U.S. debt.
U.S. citizens and U.S. institutions, the Social Security Trust Fund, the U.S. Civil Servant Retirement Fund and the U.S. Military Retirement Fund, own 68.2% of all U.S. debt. The rest of the world, including China, only owns 31.8% of our debt.
That means that a declining dollar most likely will affect individual American’s retirement accounts more than anyone else in the world.
HOW FAST IS THE DOLLAR DECLINING?
Unfortunately, there is no accurate way of measuring the decline of the loss of buying power of the U.S. dollar. All of our methods of calculating inflation or calculating the decline in the dollar are deeply flawed.
For example, we used to be able to calculate the decline of the dollar by comparing it to the German Deutsche Mark, since the Germans rarely debased their currency. But the Deutsche Mark doesn’t exist anymore since it was replaced with the Euro.
We now try to value the dollar against a basket of foreign currencies, but the Euro makes up the largest weighting in that basket. Unfortunately, the European Central Bank is now printing Euros at a record rate in order to bail out Greece, Ireland and probably a few other countries over the next few months.
HOW DO WE CALCULATE INFLATION?
Inflation is calculated every month by the U.S. Bureau of Labor Statistics (BLS). Each month the BLS calculates both the Consumer Price Index (CPI) and the “Core Inflation Index,” which is how the government measures inflation.
Right now, over 42% of the Core Inflation Index is a calculation of basic housing prices and rents which, almost all experts agree are going to dramatically drop over the next four years. That one calculation has a major influence on the Core Inflation Index.
The problem with this is that even though experts say housing prices will continue to drop through 2014, this 42% calculation for housing makes it looks like there is no inflation in America. BUT THAT IS NOT TRUE!
Anyone who has gone to a grocery store lately knows that food prices are going up or that packages of food are getting smaller and they are charging the same price. Gasoline at the pump has hit a new 2011 high this month. Education costs are going up. Insurance is going up. And anyone who runs a business knows the costs of their raw materials are all going up. HOW CAN THE GOVERNMENT SAY THERE IS NO INFLATION?
The answer is based on how the government calculates the index. With 42% of the calculation of the index in housing values it looks like there is no inflation.
But if you are not selling a house, EVERYTHING else looks like there is inflation!
To add insult to injury, the U.S. Government changed the way it calculated inflation in 1980, after the hyper-inflation during the Carter Administration.
The Core Inflation Index specifically EXCLUDES BOTH FOOD AND ENERGY. Food makes up almost 15% of the basic CPI calculation and Energy 8.5%. Now how many people do you know that don’t eat or use gasoline in a normal month?
I know it sounds crazy to exclude food and gasoline from the Core Inflation Index, but it does help the U.S. government. The Core Inflation Index is what the government uses to determine cost of living increases, known as COLA’s, for people receiving social security and it is tied to many pensions and other benefits. This allows the government to make smaller COLA payments to retirees that are below the true level of inflation. Ungenerous people might call it a government Ponzi scheme.
The Core Inflation Index is also used to calculate the inflation rate for increases in “inflation adjusted” U.S. government bonds, better known as TIPs bonds. Because the Core Inflation Index is skewed based on deflating housing prices, PLUS THE ELIMINATION OF FOOD AND ENERGY, TIPS bonds most likely will never adequately protect investors from the true rate of inflation.
The government used the same calculation for the CPI from 1913 to 1980. In 1980, after four years of hyperinflation starting in the late 1970’s, the government changed the calculation and DROPPED FOOD AND ENERGY from the Core Inflation Index. Here is a chart that shows how much inflation we really have today based on the pre-1980 government inflation calculation.
THE REAL 2010 INFLATION RATE WAS 8.5%!
While the U.S. government repeatedly states that we currently have about 1% inflation, by using the older pre-1980 government calculation of inflation the “Alternate CPI” calculation reveals that at the end of 2010 the true inflation rate was 8.5%.
WHY IS THE PRICE OF GOLD GOING UP IF THERE IS NO INFLATION?
If you believe the Federal Reserve when it says the U.S. has effectively no inflation, why are so many investors buying gold and why is it hitting new price highs?
The answer to that question is because a large number of investment managers and very sophisticated investors know that the government’s inflation calculation is designed to under-report the real inflation rate. They know that 8.5% inflation is significant and that is why so many sophisticated investors are moving larger percentages of their investment portfolios to gold and other hard asset commodities.
HOW TO PROTECT YOUR INVESTMENTS FROM THE LOSS OF PURCHASING POWER & U.S. DOLLAR DECLINES?
Cash and U.S. Treasury bonds are one of the worst investments you can hold during inflationary times. Investors are making almost no yields off their fixed income and cash in-vestments, while inflation is reducing the purchasing power of those investments by at least 8.5% annually. When the Federal Reserve eventually starts to raise rates, there is the real possibility of capital losses in longer-term treasury bonds.
Since TIPS bonds or so-called inflation protected bonds are tied to the Core Inflation Index calculation, they most likely will not offer adequate protection against real inflation.
SOMETIMES, INVESTORS MUST HOLD CASH & BONDS
At FOXHALL CAPITAL, we have re-positioned almost all of our fixed income investments to very short durations. We are holding very few long-term U.S. Treasury investments. We want to reduce the possibility that our clients may experience future capital losses when the Federal Reserve starts to raise rates.
WHAT DOES FOXHALL CAPITAL BELIEVE IS THE BEST WAY TO PROTECT AGAINST INFLATION & A DROPPING DOLLAR?
I believe that physical commodities and commodity producers like oil and mining companies are the best way to hedge against the potential loss of purchasing power in your in-vestment portfolio due to a declining U.S. dollar.
That is why we designed the FOXHALL GLOBAL COMMODITIES & HARD ASSET STRAT-EGY.
I would first talk to your financial planner, but if you must hold significant amounts of cash, U.S. treasury bonds or other fixed income bonds, they should be moved to the shortest duration possible and in order to try and maintain those investment’s purchasing power against a declining dollar, I would recommend that you invest at least 15% to 20% of the TOTAL VALUE OF YOUR CASH AND FIXED INCOME INVESTMENTS in a broad basket of com
modities like the FOXHALL GLOBAL COMMODITIES & HARD ASSET STRATEGY.
The world is getting more and more fragile and complex. Now, anything that happens in the world seems to immediately affect the stock market.
Thinking that we have complete control over our investments, the economy or anything else in life is simply an illusion. We have little or no control over anything, as those poor people in Japan found out as their homes and families were washed away in that tsunami.
The only thing you can do is to recognize that you have no control and then do everything in your power to protect yourself.
I always tell people they should buy flood insurance before the hurricane hits. It does no good to buy it after the flood.
Inflation is here. The loss of purchasing power in your retirement investments is real.
Talk to your financial planner. Commodities and commodity producing companies like oil and mining companies could provide the flood insurance you need to maintain the purchasing power of both your equity and fixed income investments.
You may need to reallocate your portfolio BEFORE THE FLOOD!
Smith, Rick. “Buffett Warns: The Dollar Will Decline”. March 28, 2011. http://www.fool.com/investing/general/2011/03/28/buffett-warns-the-dollar-will-decline.aspx
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