Most fund managers, if you asked them in private, would likely concede that buying a 30 year bond with a yield that is less than inflation is not an ideal long term investing strategy. Yet the current price of bonds suggests the actions of the majority of investors runs counter to this. You see, it is the actions of investors, not the sound bites they (and the talking heads on TV) espouse, that are important to take note of. Bond prices the world over are more or less at record highs. Never before in history have bonds been priced so well for deflation (except for the Great Depression).
It is important to remember that those in power at the Fed are all too aware of what prematurely restricting the money supply can do, as the Great Depression demonstrated. The unprecedented stimulus measures so far have been evidence of this.
So the question I have is that if the Fed is aware of the impact of deflation and has the means to print until it is avoided, what will happen when the risk gauge shifts from the threat of deflation to the threat of inflation?
Since 2008 there has been some $3-$5 trillion additional dollars invested in bonds, depending on which numbers you read. This is on top of the already enormous sum that was in Treasuries prior to 2008. If / when inflation does start to arise, what will happen to the trillions and trillions of new dollars sitting in treasuries? Remember, the worst enemy of fixed interest is inflation–it destroys returns. It may well be that the fear of deflation would evaporate and be replaced by a very real possibility of increasing inflation.
As an investor it is important for me to ask the question, “Ok, where will the money flow then?” One likely recipient for the unprecedented levels of capital is high quality US companies that have a proven ability to produce earnings that outperform inflation. It is important to understand the structural ramifications of the money printing / fear of deflation of the last 5 years. It has lead to the bond market swelling in size and the number of shares outstanding in big companies to significantly shrink. Buy-backs by major companies have been strong since 2008.
With companies producing record earnings and reluctant to push cash to work, they have embarked on enormous buy backs. In some cases (such as ExxonMobil) nearly 20% fewer shares are available now than just a few years ago.
What happens when record amounts of money move out of treasuries and begin chasing smaller availabilities of quality shares?
Rapid price appreciation, and a big bull market!
My 3 favorite picks to sit patiently with and ride the wave of money flowing out of treasuries are:
Exxon Mobil Corporation (NYSE:XOM) – The world’s largest company and arguably one of the world’s most efficient managers of capital. Some of its figures include a 26% return on equity, a healthy dividend of 2.6%, forward PE of just 10, and virtually no debt.
I believe Exxon Mobil Corporation (NYSE:XOM) is positioned to be the recipient of large amounts of capital, chasing an inflation protected asset.
Being in the oil and gas industry, Exxon Mobil Corporation (NYSE:XOM) has the ability to profit from inflation. Increases in energy prices can assist in pricing its assets favorably. The value of projects increases as the dollar per barrel of oil extracted raises, whilst costs such as labor may not rise as much. Consider that the cost of labor may increase with inflationary pressure a couple of percent–yet the price of oil could well jump by 10%-15%.