A Comment Regarding Inflation

David W. Ogburn

The Golub Group

November 3, 2009

Several clients have asked us recently about our outlook regarding inflation and how we are positioning their portfolios in light of our outlook.

In the short-term, we do not expect inflation to become a significant problem:  while signs may indicate that we are emerging from a lengthy and severe economic recession—the longest and most severe since WWII—we believe it will take considerable time for the economy to completely heal and return to “normal”.   We believe the period ahead will be marked by slower economic growth, continued consumer deleveraging (and higher savings), increased government spending, and ultimately, higher taxes.  Together, these forces will create headwinds that will dampen economic growth for the foreseeable future.  Supporting our belief is our observation that there remains considerable “slack” in our economy: 

• Manufacturing and service capacity utilization are currently at very low levels.
• Unemployment remains high, limiting the potential for wage-based inflation. 
• Prices of most major commodities are still well below peak levels reached in 2008, and in many instances, an over-supply condition exists (e.g. natural gas).

• The monetary and fiscal stimulus provided by the federal government has, so far, resulted in no inflationary impact.  Despite a significant increase in the supply of money, the velocity of money has remained stagnant, with most of the money having gone to shore up the balance sheets of banks, and not yet making its way though the financial system in the form of increased consumer lending. 
• Increased competition has produced a deflationary effect on pricing for goods, services, and wages on a global scale.

Longer-term, we acknowledge the risk of higher inflation (and hence, higher interest rates) as the global financial system continues to heal, as economic prospects brighten and global demand picks up, and as massive fiscal and monetary stimulus begins to work its way though the system.  In light of these risks, we have positioned our clients’ portfolios in the following manner:

• We continue to invest in large cap, multinational businesses that earn an increasing percentage of their revenues and earnings from abroad and which benefit from a declining dollar.  These companies are export-oriented and conduct business in most major geographies, giving them flexibility to source raw materials and labor and shift production across various overseas markets.

• We continue to invest in companies that have a history of growing cash flows on a consistent basis, giving them the ability to pay sustainable and increasing dividends over time, historically at a rate higher than inflation.

• We continue to invest in companies that possess pricing power; specifically, the ability to raise prices on a regular basis or to pass through higher costs of raw materials and labor to customers.  Examples include Anheuser-Busch/Inbev, which following a period of global consolidation in the beer industry, recently announced a price hike that was quickly matched by competitors; Kraft Foods, which over the past year was able to raise prices by an average of 5% to offset higher agricultural commodity prices, despite a weak economy; and UPS, which tacked on fuel surcharges to their customers to offset higher fuel prices last year.

• We currently devote a significant allocation of our clients’ portfolios to the energy sector, specifically, the large-cap integrated oil companies that directly benefit from higher oil and gas prices.  Rather than investing in physical commodities, we prefer to invest in companies that create value through the physical commodity, in this case by producing, refining, and marketing the commodity to consumers.

• For our clients with fixed income exposure, we have allocated a portion of their fixed income assets to TIPS, which are directly tied to the rate of inflation.  We have also structured fixed income allocations featuring lower duration and shorter maturities, which reduces price sensitivity to inflation and higher interest rates.

Noticeably absent are any investments in precious metals, physical commodities, and/or hard assets such as real estate or raw land—areas which we consider to be outside our core competency of investing in high quality businesses at attractive prices.  Precious metals and physical commodities are considered by many to be stores of value.  In contrast, we consider companies that produce ever-increasing streams of revenues and profits to be investments that grow in value.  

It is impossible to predict when inflation will occur and to what magnitude.  In fact, there are strong proponents on both sides of the inflation v. deflation debate, each armed with convincing supporting arguments.  In taking the steps listed above, we believe we have positioned our clients well for potential future inflation should it occur.     

(c) The Golub Group

www.golubgroup.com