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Which inflation? [ClearOnMoney]
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Commentary

Which inflation?

18 Mar 2011 by Jim Fickett.

Investors need to keep an eye on inflation globally, both to pick investment destinations and to understand the market prospects of global companies. For the needs of retail investors, it suffices to keep an eye on, say, the top 10 economies and, for each, one main inflation measure.

Inflation is, of course, of fundamental concern to investors. But which inflation?

In the US, I follow only the Consumer Price Index. There are many other inflation measures (the Cleveland Fed has a useful overview), and some commentators go into great detail on the Fed's favorite measure – core PCE inflation – and various other core measures, such as the Dallas Fed's trimmed mean PCE inflation. I do not disagree that these other measures tell you something useful; but they are not in the top 100 global investing trends you need to know. The differences between the various measures are minor, usually in the tenths of a percentage point. The big questions that investors need answers on, like whether deflation is a danger, or whether inflation is rising significantly, are not answered by such small distinctions.

Most investments are negatively affected by inflation:

  1. Commodities and stocks show nominal gains that are taxed, even though they are not real
  2. The purchasing power of capital tied up in bonds is reduced
  3. Business becomes less efficient, hurting profits, and hence stocks

One way to get around at least some of these negative effects is to invest in the assets of countries where inflation is less of a danger. The advantage for points 2 and 3 above is obvious. There is an advantage for point 1 only if you are willing not to repatriate the money, perhaps by living overseas for some time.

I am not going to get into the details of choosing which country here. But to take one example, it is clear that the Federal Reserve would rather take inflation risks than growth risks, while the European Central Bank would rather take growth risks than inflation risks. So if you are choosing between investing in a US company or a very similar European company, you might choose the European company just on the basis of the more vigilant central bank.

Because high inflation is so disruptive for business, and because central bank actions to control inflation usually slow the overall economy, the inflation rate is also a key indicator of future growth. And understanding that growth is essential for any investor who holds stock in global companies, i.e., almost everyone.

So keeping an eye on inflation globally is key to two major aspects of investing, both choosing an investment destination and understanding the markets of global companies. In both cases I think it is sufficient to keep watch on inflation in the largest economies. For global markets this is obvious – if you understand 90% of, say, Coca Cola's overall sales growth, that is enough. On investing destinations, there is a great deal of information on economies and companies in, say, Europe or Brazil, with relatively little information on smaller economies. The retail investor should leave Egypt and Vietnam to the experts, and concentrate on cases where there is an abundance of public information.

Currently I watch inflation in the US, Europe, and China. I hope to add Japan, the UK, Brazil, Canada, India, Australia, Mexico, and South Korea. To keep it manageable, some of these may be updated less often than monthly.