The Stagflation Menace

The threat of a stagnant economy teamed with inflation can torment your investments. Here's how to protect your money.

By Fred W. Frailey, Editor

From Kiplinger's Personal Finance magazine, May 2008

We are constantly polling to see which stories in Kiplinger's you read and what you think of them. From that research comes a pretty strong sense of what's on your mind. For instance, if your kids have left the nest, your biggest financial concern is likely having enough saved to afford a comfortable retirement. And if you're retired, it's the dreaded possibility of outliving your money.

If that sounds like you, events are leading us in an ominous direction.

Stretched thin

What economist Ed Yardeni calls TGGBOAT -- the greatest global boom of all time -- continues full tilt. In less than 30 years, China has gone from a feudal society to the third-largest economy in the world. Expectations are also rising in India, Brazil and just about everywhere else touched by capitalism. Others see the chance to live as we do in the U.S. I salute their ambitions.

The rub is this: Prodigious amounts of raw materials are the building blocks of these better worlds -- so much so that rapidly growing nations can't seem to buy enough oil, iron ore, copper and even cotton. The Wall Street Journal recently called price run-ups in commodities another bubble. I disagree. Prices of some commodities may be ahead of reality, but in other instances there's an auctioning of scarce resources, and the bidding is bound to go higher and higher.

Let's take oil as an example. Producers are pumping it out of the earth just as fast as they can yet they barely keep up with demand. As for demand, our country consumes almost one-fourth of all oil produced, or 24.5 barrels per person annually. By comparison, the Chinese consume just 1.8 barrels per person each year; the Indians, less than a single barrel.

Now suppose those two nations, with a combined population eight times that of the U.S., increased their per-capita use of oil by just one-fourth of a barrel per year. Within a couple of years, supply would fall far short of demand. Bidding wars would be horrific.

The same is true of copper. The last huge discovery of this metal occurred two decades ago, in Chile. Copper is truly a raw material of industrial production, and the global boom has made it precious. Even cotton is squeezed. It's the textile of choice as living standards rise, yet acreage is declining in the face of rising demand.

Volcanic eruption?

I'm not talking about demand merely outstripping supply. I'm talking about demand soaring so far beyond supply that a huge burst of inflation will result. At the moment, that potential burst is rumbling beneath the surface like a volcano. If allowed to get out, it could lay waste to your retirement savings. Couple that with a weaker dollar and a listless economy, and you have a recipe for stagflation -- the marriage of a stagnant economy and inflation. Your savings would rapidly buy less and less.

You don't have to just sit there. If commodities are fueling inflation, invest in them. One avenue is Pimco CommodityReal-Return fund, which mimics movements in the prices of a basket of commodities. We'll be discussing other ways to offset the inflation devil in the months to come.

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