“Hey, whatever happened to inflation?”

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We’ve been saying for months and even years that markets can go higher. An important driver has been, and will be, investors’ negative views on the financial markets. Indeed, the higher they creep, the stronger the pessimism gets. Remarkable. In the past investors would swing from a neutral to a positive outlook and eventually reach the euphoria phase, as the markets climbed higher. Today, however, it’s criticism and complaining galore.

The same goes for the last fiscal quarter. While investors discarded equities, some sectors posted results unseen in years. Traditional indices rose by 2.5 percent (Dow Jones) to 5 percent (S&P 500), but growth sectors - technology booked quarterly profits of no less than 11 percent (!) - put up some amazing numbers on the board. We keep stressing technology as a compelling investment, because the masses are tough to convince it seems. There are many psychological scars from the past, which makes it hard for people to trust the markets. It is another sign, however, that stocks still have a long way to go before we reach the top.

Although we tend to say that we are right about our positive outlook on equities time and time again, investors are waiting for a wave of inflation. We have put this on the radar for a while now and investors are curious, and rightly so. “Whatever happened to the inflation you keep talking about?” A justified question we will try to answer in the following paragraphs, although the answer is not straightforward.

Monetary phenomenon

Inflation is often mixed up with rising prices, but those are only the consequence of inflation. Essentially, inflation is a monetary phenomenon. It reflects the amount of money in circulation: if that increases, inflation goes up. The ultimate effect of increasing prices is logical, as more units of a variable asset (money) are around in comparison to a fixed asset (e.g. commodities). This results in the need for more units of the former, to get the latter. Those who want to know how much money circulates may want to ask the central banks, as their balance sheet is largely representative. And because America is the supplier of the world reserve currency, the balance sheet of the Federal Reserve is the ultimate measure of inflation.

Fed base

Balance sheet of the Fed; Source: St. Louis Fed

Looking at the chart of the Fed’s balance sheet above, one immediately notices an inflation explosion. This is monetary inflation, of course, but the effect of this has not really trickled down to our daily lives and there is a good reason for that: the velocity of money collapsed at the same time (see the chart below). And that is because of the fact that the money created by the Fed is still stuck in bonds and other debt securities. Moreover, a major part of the money reserves is parked in banks. Consequently the ratio – the velocity of money – has plummeted in recent years. Not because there is less money in circulation, but because more of the money is tied up.

Velocity of M2 money

Velocity of the money reserves of the Fed; Source: St. Louis Fed

The spectre of inflation is looming

This cannot go on forever. This monetary experiment will come to an end one day, forced by the market. You can probably guess what the outcome will be: an enormous increase in prices. It is a guessing game, naturally, to figure out when and how this will happen. It could be years before anything happens at all, but anything could happen anytime. This is called hyperinflation. No matter how this will pan out, higher price levels are unavoidable in the long term. It would be smart to not wait until the hurricane hits shore, but look for possible escape routes beforehand.

This wave of inflation will have a big impact on our standard of living, but most importantly on the buying power of your capital. Investors who have parked their wealth in assets such as bonds or savings accounts will have to face the music and deal with this devaluation. Investors with a big chunk of their capital invested in real assets are protected against the destructive effect of inflation on their purchasing power. Take your precautions. Invest in quality companies in sectors that will support our future, invest some in gold and some in commodities. The clock is ticking!

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Sprout Money offers a fresh look at investing. We analyze long lasting cycles, coupled with a collection of strategic investments and concrete tips for different types of assets. The methods and strategies from Sprout Money are transformed into the Gold & Silver Report and the Technology Report.