Thinking about the deficit as you invest

by Pop on February 18, 2011

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The “crisis” that never comes

The recent deficit talk has people rightly concerned about whether or not Congress and the President have the cojones to bring our fiscal house in order. There are basically four ways to cut the deficit: grow the economy, cut spending, raise taxes, or print money.

Option one is the fun way to get out of it. If we sell more goods and services, government collects more taxes while citizens make more money, and everybody’s happy. However, the economy right now is growing slowly.

Options two and three are where all the debate is happening. However, political risk is frightening most politicians from addressing the beasts of healthcare and Social Security that need to be tamed for any real progress to be done.

Which leaves option four as the default way to pay. If Congress does nothing to fix the deficit, the government can “print money” to devalue those debts, which drives interest rates up and the dollar down. Bad for savers. Good for debtors.

While you might understand how all that could eventually affect inflation and the prices you pay for goods, you might be left scratching your head about just how much of a knock on your savings that last solution could translate to.

Here’s an attempt to explain it without getting too wonky or insulting your intelligence. But first, let’s set one thing straight.

Inflation is not here yet.

I’m kind of tired of the “is there or isn’t there” inflation debate going on right now. The government’s official inflation measure showed that prices rose by about 1.6% over the last 12 months. Food and energy prices accounted for more than two-thirds of the increase.

Inflation of less than 2% is extremely low, especially when you’re including food and energy prices, which swing up and down sharply based on crop yields, hurricanes, etc. Critics like to counter with nice-sounding anecdotes about how their personal grocery bills are rising. But even if we were to accept anecdotal evidence as valid, there’s reason to think those anecdotes are wrong.

Here’s the average grocery store purchase at a Hy-Vee in Des Moines, according to Mint:

This chart is based on data aggregated anonymously from over 4 million Mint.com users.

Go to Mint’s data feed yourself and play around. Grocery bills aren’t going up. Unless people are eating less, or deciding to make multiple trips to the store in order to keep their average order down (diabolical!), it’s simply not true that grocery prices are already on the upswing.

But it could happen soon. As the WSJ points out today, the prices for some things are rising faster, and inflation is already much worse in places like China, where there’s not a bad economy to weigh against price increases.

I’ve written before about good and bad inflation fighters. But today, I want to write specifically about how rising interest rates could affect stock prices.

Starting with a risk-free rate of return

If you wanted there to be no chance for your investment to lose money, where would you put it? FDIC-insured bank accounts come to mind, but you’d do slightly better by investing in 10-year Treasury bonds, which yield about 3.6% a year right now. Don’t get me wrong. If interest rates rose while you had your bond, the price would go down in the interim. But as long as you held onto them for the entire 10 years, you couldn’t lose a dime unless the federal government were to default.

That’s about as close to risk-free as investors can get right now. And that means that anything they invest in that carries more risk needs to pay out more than 3.6% a year to make sense as an investment.

The bonds of Warren Buffett’s Berkshire Hathaway, for example, would seem to be extremely safe. It’s a big, established company that’s generating a lot of cash. But the yield of a Berkshire bond I’m looking at that matures in 2021 is 4.2%. That means that as safe as Berkshire is, investors want another 0.6 percentage points to take on the ever-so-slight risk that Berkshire goes belly-up before the bond matures.

As you can imagine, once you start getting down to auto companies, those bond yields start to get really high.

What it means for stocks

Stocks also have a yield, though personal finance magazines like to make it appear more complicated than it actually is. The “price-to-earnings” ratio that you read about all the time is really just an earnings yield in reverse. A stock with a P/E of 15, for example, has an earnings yield of 6.7% (1 divided by 15).

Since stocks are more risky than bonds, investors want to pay a price on a company’s stock that reflects the additional risk they have to take on. The price-to-earnings ratio of Berkshire Hathaway, for example is 17.6, which translates into an earnings yield of about 5.7%. (Admittedly, a P/E isn’t the best way to evaluate a holding company like Berkshire.)

So, what happens when the interest rates on Treasury bonds rise? Let’s say the interest rate on a 10-year Treasury bond went to 10%, as it was in the early 1980s.

An investor could earn 10%, while taking no risk, by buying Treasury bonds. So if he considered buying a stock, which carries a lot more risk, instead, he’d want to get a yield that’s better than that.

The earnings yield of the S&P 500 right now is about 4.3% (which is a P/E of about 23). So to get even close to the 10% yield of a Treasury bond, you’d need stock prices to fall by more than half.

In reality, the drop would be much less sharp—earnings would rise, too. But P/E compression, as the phenomenon I just described is called, is a very real fear that investors haven’t had to face for 20 years, since during that time bond rates kept dropping.

Long story short…

If investors fear inflation, and start to demand higher yields from Treasury bonds, that will mean that stock prices will have to make a corresponding drop, all else being equal. Stocks have benefited from a 20-year or so long-term drop in Treasury yields. But that party’s over.

Is there anything you can do to protect yourself from it? Not really. You could choose stocks that already have low P/Es, with the idea that those prices won’t compress as much when interest rates rise. However, buying individual stocks carries so many other risks, that it’s probably not worth your time, effort, or emotional fortitude to go through all that.

It’s just one of those things that you should save more to prepare for and to understand once it does start to happen. This deficit monster is probably going to extend its tentacles into more aspects of our finances than we can even conceive of.

I, for one, am hoarding piles and piles of gold bullion in an undisclosed location. So when Zimbabwe-like inflation causes food riots, I can…eat it…or something.

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