Even When Low, Inflation Can Hurt

NEW YORK (TheStreet) -- Inflation fears have subsided as the economic outlook has darkened once again. This is boosting the dollar and sending gold prices lower while many observers are pushing the Federal Reserve to take more drastic monetary policy actions to support the economy as a gridlocked Congress stands idle.

Even if policymakers overlook the threat of inflation, though, investors shouldn't forget the damage that even low-level inflation can have on their holdings -- particularly at a time when interest rates are at record lows.

The Consumer Price Index, which is the official reading of inflation in the U.S., has increased by 1.7% over the last 12 months through May, according to the U.S. Bureau of Labor Statistics. That marks a steady decline from the 3.9% peak last September, and it's a historically low level. Meanwhile, Federal Reserve Chairman Ben Bernanke said Wednesday that the Fed's Open Markets Committee foresees prices remaining stable with the inflation rate at or below the central bank's 2% target.

The market appears to agree, with futures prices showing a decline in expectations for inflation over the next five years. All this provides fodder for those who have argued that the U.S. economy is facing a deflationary predicament, dismissing arguments from opposing camps that the extraordinarily accommodative stance of the Federal Reserve in response to the financial crisis and its aftermath will spark an outbreak of inflation.

Still, when investors are scrambling to buy 10-year Treasuries at a yield of less than 1.7%, I think we can all agree that even modest inflation at a rate of 1.7% is devastating. Investors that hold a 10-year Treasury to maturity under these circumstances are facing the unwelcome prospect of suffering a long-term decline in the value of their holdings in real terms. Inflation is completely wiping out their yield.

Sure, yields on Treasuries could go lower, sending prices higher and giving holders the prospect of a capital gain if they're willing to sell. But we're already at record lows. How much lower can we go? I would submit that buying Treasuries and other investment grade bonds at current prices is not a "buy-low, sell-high" strategy -- quite the opposite, actually. And let's bear in mind that the whole point of investing is to buy assets at a low price and sell them at a higher price.

I recently heard Steve Mandel, founder of Lone Pine Capital, say at a conference that investing in today's fixed income markets is a "Heads, I win very little/ Tails, I lose very big" proposition. And the estimable James Grant, longtime Wall Street chronicler and the author of the widely respected newsletter Grant's Interest Rate Observer, has called the bond market a "value desert." Investors who are viewing fixed income as a low-risk investment may want to rethink their assumptions in the current climate.

Unfortunately, the stock market doesn't seem particularly inviting at the moment either. The global economy is in trouble, with China slowing and the crisis in Europe weighing on the U.S. economic recovery. I'm by no means predicting a double-dip U.S. recession now, but the risk is certainly elevated, and I can understand why investors are wary of buying into stocks after everything that has transpired over the last decade.

The good news about stocks is that many strong and steady U.S. corporations are sporting far more attractive dividend yields now than anything you'll find in fixed income without delving into riskier credits. Shares of pharmaceutical giant Merck ( MRK) , for instance, are yielding 4.3%. Questar ( STR), a natural gas utility company in the Rocky Mountain region, yields 3.2%. Exxon Mobil ( XOM) yields 2.7%.

Moreover, stocks offer a natural hedge against inflation, since companies tend to benefit from charging higher prices even as they pay higher prices, and the long-term prospects for capital gains on stocks are far more attractive than bonds right now from a valuation perspective. Stocks have certainly proven to be a superior long-term investment throughout modern U.S. history, even during calamitous events like the Great Depression and world wars.

If you think we're headed for another train wreck and the stock market is going lower, you can sit in cash and wait for the bottom to buy stocks, but it's hard to thread that needle without a crystal ball or a time machine. And remember, even at a time when the dollar is gaining strength relative to other currencies, it's still losing purchasing power over time at the hands of inflation, which brings me back to my original point.

If anything, government statistics understate the rate of inflation. Most Americans would probably agree that the CPI doesn't reflect the extent to which the cost of living has gone up over the years and their dollars don't buy as much as they once did. And even the official rate of inflation is likely to go higher from here over time. In fact, many widely respected authorities -- from former Fed Chairman Paul Volcker to Berkshire Hathaway ( BRK-A), ( BRK-B)) CEO Warren Buffett -- have warned that the extraordinary monetary actions that are being taken -- and are still likely to be taken -- by the Fed and other central banks around the world raise the risk of higher inflation sooner or later.

I wouldn't want my portfolio to be in cash when that day arrives.

This commentary is from an investment professional with Clear Harbor Asset Management who is a participant in TheStreet's expert contributor program.

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