Effects of inflation on value of investment

July 6th, 2008

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Continuing from Measuring the value of an investment, we learnt about measuring the value of an investment relative to the risk-free returns of long-term government bonds. But that does not take into account the effects of inflation on your investment. This is a factor that is often forgotten, which in this age of rampant monetary debasement will seriously undermine your investment returns in real terms. As we said back in February 2007 in Have we escaped from the dangers of inflation?,

Today, the global spigot of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of ?liquidity?) is wide open, spewing out huge amounts of money and money substitutes into the [global] financial system.

The world was lulled in to a false sense of seemingly low price inflation through the rise of Chinese manufacturing power. Consequently, this gives investors a false confidence of fiat money being a reliable store of value. Today’s climate of rampant global price inflation is payback time for such economic folly. If we are right, the world is marching towards stagflation (low/negative economic growth, rising unemployment and rising prices) along with a deflation in asset prices. This is the worst environment for investors.

Inflation is a relatively new phenomenon in the latter half of the 20th century. As we quoted the late Professor Murray Rothbard in A brief history of money and its breakdown- Part 2,

Since the U.S. went completely off gold in August 1971 and established the Friedmanite fluctuating fiat system in March 1973, the United States and the world have suffered the most intense and most sustained bout of peacetime inflation in the history of the world. It should be clear by now that this is scarcely a coincidence.

Under the good old days (prior to the First World War) of the gold standard, there was no such thing as inflation (except for periods of war). Prices were relatively stable over the centuries. In fact, they tended to fall because of economic growth (similar to why the prices of computers and technology products fall because of increased productivity). For more information, you may want to refer to our guide, What is inflation and deflation?.

Therefore, as investors, you have to understand the relation between the value of your investments and inflation.

First, how are long-term government bonds priced? As you may already know, the free market sets the prices of long-term government bonds. As we explained before in Measuring the value of an investment, the price is inversely related to the rate of return (yield).

In theory, the price of long-term government bonds reflects the market’s expectation of long-term price inflation. Assuming that the market is right about long-term inflation in its pricing of the bonds, the value of your investments will automatically factor in inflation. Hence, as we said before in Is the value of an asset its price?, since the value of an asset is relative to the long-term government bond, the value of a long-term government bond is relative to price inflation.

Now, what happens if you believe that the market is severely underestimating long-term price inflation (i.e. the price of long-term government bond is way too high)? This is the situation that we reported in Marc Faber: Bernanke Policy Will ?Destroy? U.S. Dollar, where Marc Faber said that the 10-year and 30-year US Treasury bond market was (and still is today) a “disaster waiting to happen.” Notice what he said:

The arguments for stocks is frequently that you take the earnings yield of the stock market and compare it with the bond yield and people compare it to Treasury bonds. I think you should take the earnings yield of equities and compare it with, say, a typical S&P company, and that is a yield that correspond to, say, a triple-B, and so, basically as of today, some bonds are more attractive than equity.

What do you think will happen to stock prices if one day, the US Treasury market correctly reflects price inflation?

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