‘Slugflation’ may lie ahead

The bear market and recession that began late in 2007 are perhaps barely half over, but it isn’t too soon for financial planners and investment advisers to begin preparing clients for the aftermath of government efforts to halt the crisis.

That aftermath is likely to include inflation and sluggish growth.

Inflation seems likely because of the huge increase in the federal deficit and the money supply produced by the government’s efforts to recapitalize the financial institutions to encourage them to lend, and to stimulate the economy through tax cuts and government spending.

The deficit is expected to reach $1 trillion for fiscal 2009 and certainly will be higher when the Obama administration puts its stimulus package into place.

A trillion-dollar deficit would be equal to almost 7% of the nation’s gross domestic product, high by historic standards, and normally would be inflationary.

Meanwhile, the Federal Reserve Board has boosted the money supply at a very rapid rate. For all of 2008, currency in circulation and demand deposits, known as M1, grew by 11.5%, while the slightly broader M2, which adds individuals’ savings accounts, grew by 7.6%, both worryingly fast.

However, the rate of growth of both money measures accelerated in the second half.

From July through December, M1 grew at a 22.6% annual rate, and in the final three months, it grew at a 36.9% annual rate. M2 grew more slowly, at a 7.7% annual rate in the final six months and then at a 13.8% annual rate in the final three months, at a time when the GDP was declining.

This boost in the money supply was an attempt by the Fed to bolster the sinking economy. But when the money supply grows significantly faster than the economy for any significant period, inflation usually results.

The Fed might be able to prevent significant inflation if it reins in the rate of growth of the money supply quickly and the economy rebounds quickly, but neither seems likely at present. In fact, there is a danger that the federal government will use inflation to ease the burden of repaying the debt it is issuing.

Therefore, the prudent strategy for investors is to prepare for the possibility of inflation in the next few years by diversifying portfolios into investments that perform well in inflationary times, such as commodities.

Common stocks have delivered gains of 4% to 7% during periods of modest inflation but wilt under higher inflation — which is deadly for bond holders.

Compounding investors’ problem is that slower economic growth is likely over the next few years. Most major investment banks became commercial banks to gain access to federal rescue money, which means that they will be subject to tighter regulation and unable to use as much leverage as in the past, impeding their ability to finance corporate growth.

Non-financial companies also will find it more difficult to use leverage to spur growth, even if they were so inclined. This suggests that real economic growth, and growth of real corporate earnings, will be slower in the next few years, implying lower equity returns.

Wise financial planners and investment advisers should now be helping clients review and perhaps restructure their investment strategies and portfolios.

While a miracle may allow the Department of the Treasury and the Fed to restore economic soundness and growth without igniting inflation, investors should prepare for a less divinely influenced outcome.