Although a number of economists are still concerned about deflation, there is a growing concern on the part of other economists about inflation. Irwin Kellner, the economist at MarketWatch, had an article with his take on the topic recently. One thing that is clear is that inflation is partly a child of globalization. A recent Yahoo! Finance article on Starbuck’s planned price increase makes that clear:
The upcoming agony of Starbucks devotees offers three fundamental truths that should be apparent to all who pay attention to economic news:
(1) global growth is strong;
(2) U.S. growth is weak compared to global growth;
(3) the world’s national economies and markets have never been more connected or interconnected.
The global economy continues to recover from the plague year of 2009 — the first since 1944 in which the world’s economic output shrunk. The International Monetary Fund pegs growth at 4.5 percent for 2010.
In nearly every corner of the world, more people are building and eating more stuff. That has pushed up prices for a range of commodities — steel, copper, cotton, soybeans, wheat, and cotton. Many commodities (notably oil and gold) are priced in dollars. Slow U.S. growth, which weakens the dollar, can also have the effect of making commodities more expensive.
But it’s the third factor — the rising tide of globalization — that is making venti-size waves at Starbucks and elsewhere. In an era where production of key staples and finished goods can happen anywhere, so too can problems. Coffee is expensive in part because of poor harvests in Vietnam and Colombia. Bloomberg reported on Monday, that “raw sugar rose to a seven-month high in New York on concern that suppliers will struggle to meet demand.” A big part of the problem: “Drought in Brazil, the world’s biggest producer of coffee and oranges as well as sugar, is harming crops and drying the Amazon River to its lowest in 47 years.” For farmers in Brazil, Antonio Carlos Jobim’s Waters of March can’t come soon enough.
In other areas, the problem is too much water. Bloomberg notes that “sugar-cane yields in Uttar Pradesh, India’s biggest cane producer” could be harmed by recent flooding. The price of a pound of sugar for delivery in October has soared 67 percent in the past few months (For current prices on agricultural commodities, check out the CME Group’s website.)
Since inflation is a global phenomenon, it’s not going to be possible to counteract it with a new government policy. Inflation is bigger than any one government, so we’re just going to have to deal with it. Here’s the big problem: most investors do not have the resources to deal with inflation.
Rob Arnott has an outstanding article on the inflation problem for 401k investors. (You really need to read this article all the way through. Important stuff.) The problem with most 401k plans is that investors do not have sufficient flexibility to deal with inflation if it crops up:
The evidence supports this: investors hold between 55–75% in stocks and 25–45% in short-term fixed-income and bonds. Most 401(k) plans have a money market or stable value option, and one or two bond funds providing fixed-income exposure. But, on average, only 5 of the typical 18 investment choices are non-stock funds! With stock funds comprising 70% of our available choices, it’s no coincidence that the average 401(k) investor has roughly 70% of their 401(k) in stocks.
I’d generalize things even further: even outside a 401k plan, most investors do not have the expertise to use an alternative toolset to deal with investment problems that they have not been seen in their investing career. Inflation requires that alternative toolset. Mr. Arnott thinks there are four critical components:
An effective real return strategy should have four key components:
1. Inflation-fighting assets such as TIPS, REITs, and commodities should be blended into the portfolio in a meaningful way.
2. Non-dollar assets should be used on a scale large enough to protect against any government choices that may debase the dollar. Of course, Japan and Europe face the same “3-D Hurricane” that we face here, only more so. So, these non-dollar investments should be in the emerging markets, in the local currencies. It bears mention that the emerging markets largely shrugged off the “global financial crisis” and the “great recession.” Why? Most did not have massive debt. Most did not respond to the crisis with massive deficit spending and new debt. And most chose to let failing enterprises fail instead of propping them up.
3. There should be investments in inflation “stealth fighters” such as high-yield bonds, bank loans, convertibles, and local currency emerging markets debt. Inflation stealth fighters work in a subtle way. Inflation reduces the real value of the debts, improving debt coverage ratios. As the coverage ratios improve, the credit spread can narrow creating capital gains on top of the original rich yields. This leads to startlingly high correlations between their returns and the rate of inflation.
4. Tactical allocations among the asset class choices. Higher inflation breeds volatility which, in turn, breeds opportunities to be tactical in response to price dislocations. This includes the ability to invest in absolute return, low beta, alpha-oriented strategies for times when both traditional and real return funds offer meager risk-adjusted returns.
That is a handful. Excuse me for believing that Mom and Pop are not prepared to deal in TIPs, REITs, commodities, high-yield bonds, bank loans, convertibles, and emerging markets debt and equity, let alone make knowledgeable tactical asset allocations among them! Most investors have enough trouble making money in boring stocks and bonds.
Our Global Macro portfolio (and the Arrow DWA Tactical Fund, DWTFX) is designed to deal with this very problem. It allows an investor to rotate toward strong asset classes, whether in domestic equities, international equities, emerging market debt and equity, REITs, commodities, inverse funds, currencies, inflation-protected securities, and more traditional fixed income. Both exposure and timing are addressed so that Mom and Pop-who have no expertise-don’t have to try to figure out what to buy and when. Best of all, the portfolio adapts as strength in various asset classes waxes and wanes. Market regimes change, and while Mr. Arnott is concerned about inflation now, it is possible that an entirely different concern will be on the horizon a few years from now. Global Macro is designed to roll with the changes.
To receive the brochure for our Global Macro strategy, click here. For information about the Arrow DWA Tactical Fund (DWTFX), click here.
Click here and here for disclosures. Past performance is no guarantee of future returns.
Posted by Andy Hyer 
