Cutting Through the Hot Air -- Part II

 | Feb 12, 2013 | 9:30 AM EST  | Comments
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In part one of this piece, in preparation for the cantankerous economic debates ahead, we sifted through a couple of the common misconceptions disseminated by Washington and the media. Here we address one more -- as well as how all this should shape your investing decisions.

"You are a slow learner, Winston."
"How can I help it? How can I help but see what is in front of my eyes? Two and two are four."
"Sometimes, Winston. Sometimes they are five. Sometimes they are three. Sometimes they are all of them at once. You must try harder. It is not easy to become sane." 
-- George Orwell, 1984 

Living In A Nominal World 

What is real in gross domestic product anyway? Quite correctly, the nominal GDP is "deflated" by a measure of inflation in order to see how much the economy actually grew. The growing controversy is that GDP is deflated using a separate measure -- the GDP deflator -- as opposed to the Consumer Price Index for All Urban Consumers (CPI-U), which is used to generally measure the inflation you and I experience every day. The GDP deflator is generally always lower than CPI, thus yielding a higher level of real GDP growth.

Briefing.com noted that, if the deflator were unchanged from the third to the fourth quarter, real GDP growth for the latte rwould have been a shocking -2.21%. The always illustrative Doug Short calculated that, using CPI, fourth-quarter real GDP would have been a distressing -1.56%. (Note, too, in his chart that the Great Recession indeed was "great," in a bad sense -- far worse than "headline" numbers.)

Nominal GDP, Adjusted With CPI
Source: dshort.com

Some pundits are arguing now to just pay attention to nominal GDP. If it is growing, they say, that is all you need to know. There is an element of usefulness here, in the sense that the nominal stock market will react to nominal earnings and nominal interest rates. Of course, going "all nominal" gives the Federal Reserve cover to continue to accelerate inflation, so beware of the motivations of any pundit making this argument. 

* * *

"There was truth and there was untruth, and if you clung to the truth even against the whole world, you were not mad." -- George Orwell, 1984 

Investment Implications 

As I survey the quality of discourse, the attempts to spin the discussion of government spending and its role in our economy, a few thoughts become crystal clear: 

1. Federal outlays will remain far higher than any supposed deal will posit, and extremely large U.S. deficits will be the reality for the next few years.

2. The deficits will not be financeable by the private sector alone, so the Fed will be required to monetize the debt for the foreseeable future.

3. Accelerating inflation is inevitable, although we don't know the pace thereof, nor how visible it will be in the "official" statistics. For the best measure of inflation, ask your spouse about recent experiences at the grocery store and gas station.

4. Learn from history: what sectors worked, then later didn't "work," in periods of overly loose monetary policy, such as the late 1990s and the mid-2000s.

5. Protect yourself from accelerating inflation and, in particular, have some hedge to protect against the black swan of hyperinflation. I call it a "black swan" because, while the odds of a hyperinflation in the U.S. are slight, the effect on your wealth will be devastating if it happens. Remember, risk control is not strictly the probability; it is the probability times the magnitude of effect. An eight-sigma event that can wipe you out is worth as much consideration as a one-sigma that could cause a 5% decline.

6. I am positioned for inflation protection with:

  • Owning stocks, especially those with pricing power. Amid strong inflation, stock prices will rise, and companies with pricing power -- such as tobaccos or consumer staples -- will see growing earnings.
  • Commodities and real estate are also great inflation hedges. All tangible assets -- anything they are not making more of -- will hold their real value.
  • Own some gold as a hedge against all paper currencies.
  • Diversify out of the major currencies and into the new hard currencies, such as Canadian or Australian dollar, and so on.

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