Current investment prospects are so cluttered with uncertainty and unusually high levels of risk that we’re compelled to approach investment decisions from a perspective of caution. And of the many different concerns, inflation may be the most difficult. Long term risk appears highly skewed toward inflation, as we read the evidence. Yet the near term holds significant risks toward deflation such as deleveraging and general headwinds to economic growth, making for unusually complicated investment choices.
The Fed’s monetary response to the credit crisis and now the European Central Bank’s massive loan program certainly focus attention on the long term prospect of inflation. So too does the untenable nature of the developed world’s debt and unfunded liability problem (given that the only options are some combination of default, austerity, and inflation – that is, paying off debt with inflated currency in the future – of these, inflation will generally be the most politically palatable). But lately, we’ve pondered a different issue that promises to have a significant impact on future inflation – demographics.
Demographics, the study of human population trends and distributions, operates in a relatively certain sphere in contrast to the uncertainty that permeates political science, economics and finance. It’s often said that demographics is destiny, and it’s true: “predicting”, for example, the number of individuals that will be sixty-five years old in ten years is not much of a stretch if one knows the number of fifty-five year olds today. Modify that a little for the fairly predictable impact of mortality and immigration and you’re there.
Demographers tell us that ten years ago there were about ten people entering the domestic workforce for every one retiring. They also point out that by 2020 (just 8 years out!), that dynamic will reverse: there will be ten reaching retirement age for every one new entrant to the job market. That’s an astonishing prospect to consider! To be sure, things are unlikely to turn out quite so extreme: in such a circumstance, fewer will be able to afford to retire when they might otherwise desire to, and immigration could become welcomed as a solution (rather than perceived by so many as a net problem). But such influences can only mitigate such an extreme condition. They can’t turn it around.
The implications of such a shift are many: The healthcare and social services burden of an aging population are well publicized, as is the likely impact of demographics on our federal budget and debt. Far less attention has been given to the likely impact of demographics on the labor market, but it promises to be significant. Today’s chronically high unemployment should disappear after not too many years of multiple retirees for every new worker. It also raises the prospect that we may not be able to produce all the goods and services retiring Baby Boomers may demand! And imagine the wage competition for the relatively few new graduates entering the job force. Additional capital investment and productivity gains would likely mitigate, but could not eliminate the impact of a shrinking workforce.
Just like the market for oil, the job market is only one market in the overall economy and rising prices in any one market because of a shortage of supply do not automatically equate to a rise in “general price levels”, that is, to general inflation. But the prospect of a shrinking workforce is another story. That raises the specter of a shrinking general supply of goods and services. Unless that reduced supply of goods and services is matched by a proportionate reduction in the money supply (unlikely, in our view), inflation results. Therefore, demographics likely lead to both lower economic growth and higher inflation.
Given a unique brew of monetary policy, debt, and demographics, we consider upward pressure on inflation to be highly likely in the long run. That, of course, leads to the question: “what should be done about that in portfolios today?” Unfortunately, as clear as the long term inflation picture appears, the near term, as we’ve previously said, is murky at best.
We hear and share the long term inflation concerns expressed by many clients. And yes, today we hold in managed portfolios more inflation hedges than we have heretofore: more gold, more diversified commodities, more managed futures, more oil and gas interests, more real estate. Furthermore, we seek to generally add to those hedges in the future given opportunities of price weakness. But we also recognize (and remind clients) that many of these investments are inherently volatile in price, and that commodities prices tend to be highly correlated with economic activity. That means increased concerns about slower economic growth could send the prices of most inflation hedges tumbling. So, as we weigh the long term risks of inflation against the near term price risks of inflation hedges, we track a measured, moderate approach. Patience is perhaps the most difficult investment trait to develop, but it is the one generally most rewarded.