In my many years in Wall Street, I do not remember the analyst landscape being so divided when it comes to future projections of inflation.  Economists and market participants are almost equally split in the great debate on whether the next few years will produce inflationary pressures or deflationary forces.

The debate is not only an academic exercise of course as it has massive ramifications on what kind of response we should be expecting from the Federal Reserve and therefore what kind of portfolio one should build.

Conventional wisdom calls for overweight in commodities and real estate if one expects higher inflation rates; bonds should also be avoided, especially long duration and fixed coupon securities.  On the other hand, bonds may be an investor’s best friend in a deflationary environment.  As far as stocks, they are usually a negative asset in deflationary times but in a rising inflation environment, their returns depend on the degree of change.

A recent study by Andrew Garthwaite illustrates how stocks tend to disappoint when inflation falls below 2% (indicating a possible slide into deflation and subsequent loss of pricing power) and when inflation rises above 4%.

In terms of our present situation, we also have to consider two entirely new variables: the Fed’s balance sheet and the historically large fiscal deficits.  In the long term these two variables would seem to favor an inflationary outlook and a rise of real yields.  However, Garthwaite believes that real yields will remain compressed as the result of financial repression. Garthwaite points out the $8 trillion of excess leverage in the developed world and $13 trillion more government debt than in 2008.  He believes that 1% off real rates reduces the amount by which fiscal policy needs to be reduced by 1% and increases GDP growth by 0.5%.  In his view, as inflation expectations rise, real yields will actually fall (nominal bond yields will rise but not as much as inflation expectations).

This thesis implies the Fed can keep control of the bond market even in a situation when inflation expectations de-anchor.  That may be but we have no historical precedent.

Garthwaite best hedges against the scenario he believes will develop:

-          Real Estate in US, Germany and Japan (all three among the cheapest globally)

-          Companies with inflation linked pricing

-          Growth stocks

-          Gold stocks

For those investors who believe that inflation AND real yields will rise simultaneously he suggest short duration stocks with negative working capital such as food, retailing and telecoms.