With signs pointing toward inflation, investors should take precautions

//August 18, 2008

With signs pointing toward inflation, investors should take precautions

//August 18, 2008

The demise of Bear Stearns, failure of IndyMac Bank,
troubles at U.S. mortgage giants Fannie Mae and Freddie Mac and the housing
debacle, coupled with the nasty de-leveraging process saw our markets and
economy on tenterhooks. Each time, we escaped with minor setbacks, clearly
reflective of the resilient and agile nature of our financial structure. But
something more ominous is gaining momentum that could potentially rattle the
economy if kept unchecked: inflation.

Economist John Maynard Keynes once said: “Inflation is a form
of taxation which the public find hardest to evade and even the weakest
government can enforce when it can enforce nothing else.” Unfortunately, not
much light is being shed on this issue, and our Fed is under the illusion that
inflation is under control. Something significant is about to unfold because a
variety of factors could converge to drive inflation to disturbing levels.

An analysis of the most vicious inflationary periods in
recent history has shown that inflation primarily finds its roots when money
supply increases dramatically. This creates a condition where more money chases
the same goods and services, hence driving up price. But now, in addition to an
oversupply of money, other factors, like high commodity and agricultural
prices, imported inflation, rising Producer Price Index and a weak U.S.
currency, will contribute to drive up inflation.

Money supply exploding: The Fed and the Treasury have our
printing presses on overtime, and money is being printed and pumped into the
economy at an alarming rate. The sharp cuts in interest rates from 5.25 to 2
percent in a few months accelerated borrowing by banks and expanded money
supply in the form of credit. Amidst the turmoil, Congress approved a $150
billion stimulus package, adding more money into the system in the form of

Lost in all this noise was a disturbing and vital piece of
news that received no coverage. The Treasury/Fed decided to stop publicly
releasing M3 money-supply information. M3 is an extremely important number
because it is the broadest measure of money circulating in the economy that is
tracked closely by economists. This number gives a clear picture of how much
money is in the system. Having been publicly available for decades, no rational
explanation was given for this retraction. Although less accurate measures of
money (like M1 and M2) are still available, it severely hinders the capability
to quantify the amount of money in the system.

Imported inflation: Textiles, electronics, furniture, toys
and now even inflation is made in China. Many developing Asian economies that
export heavily to the U.S. are experiencing high levels of inflation. Central
bankers and regulators in India and China are fighting vigorously to tame
inflation, sometimes even at the cost of growth. But inflationary forces are
still largely at bay in those economies, and a significant portion of that
inflation gets imported into the U.S. through their exports.

This unfortunate phenomenon significantly affects our
inflation, rendering the U.S. government helpless because this inflation is
imported. This particular source of inflation is not about to decline soon and
has to be tackled.

Rising agricultural/commodity prices and PPI: Significant
price rises in commodities, agricultural and food products are inciting
widespread agitation here and around the world. The Producer Price Index (PPI)
is widely considered a leading indicator of where Consumer Price Inflation, or
CPI, is headed. Measuring inflation in primary input articles for a wide array
of manufacturers, the PPI reflects the rising cost of production and
manufacturing that will eventually be passed on to consumers. Even this number
has been on the rise, raising several red flags, which the Fed has chosen to
ignore. There seems to be no reprieve for the PPI, which is a disturbing sign
going forward.

Misery Index: Many economists track the famous Misery Index
(unemployment rate plus inflation) which is currently at 10.72 percent
(unemployment at 5.7 percent and inflation at 5.02 percent). The appropriately
worded indicator basically reflects the overall mood of the economy, and the
signs don’t look sanguine going forward.

All these factors will converge and drive inflation higher,
so now is an appropriate time to look at your portfolio for asset re-allocation.

Your money: Usually high inflation periods result in
super-low real returns when invested in the stock market. (For example, if the
stock market is up 15 percent and inflation is at 10 percent, your real return
is 5 percent.) This is primarily because of U.S. dollar devaluation and loss of
purchasing power. The majority of

local and dollar-denominated investments will drastically
underperform and here are some ideal avenues to park your funds in this

1. Buying foreign currencies via exchange-traded notes (ETN)
or, even better, buying foreign currencies directly.

2. Investing in government bonds with high yields from
commodity-rich countries such as Australia. Here you are positioned to gain
from currency appreciation and bond yields.

3. Shorting the U.S. dollar via exchange-traded funds (ETF)
like PowerShares’ DB US Dollar Index Bearish Fund.

4. Purchasing Treasury Inflation-Protected Securities.

5. Purchasing significant quantities of gold, silver or
other precious metals as a hedge.

6. Buying ETFs, ETNs and their options that track inflation.

7. Generally divesting from dollar-denominated assets.

Adhvith Dhuddu is a recent graduate of Virginia Tech who
wrote a financial column for the university’s Collegiate Times newspaper. On
his Web site at www.moneywhizdom.blogspot.com, he posts his columns on trade,
commerce, investing and personal finance. He lives in Harrisburg.