Inflation or Deflation—Who Can Tell?

Whatever the future, you can protect yourself with an "armadillo strategy."

In the last decade, the world economy has become increasingly complex and unpredictable. Today, depending on the evidence being considered at the moment, you can make a compelling case for deflation and depression, hyperinflation, and every economic scenario in between. As an economic and monetary analyst, I have my own carefully considered opinions on the subject. However, they are opinions, not guarantees of the future. No one can be absolutely sure what tomorrow will bring.

The major protagonists in the deflation versus hyperinflation controversy are urging investors to choose sides. They claim an individual's financial future depends on betting the right horse. This may be true for speculators trying to make a killing in the financial markets, but it is emphatically not the case for capital-preservation-oriented investors, who should be preparing themselves for any economic eventuality.

The "Financial Armadillo Strategy" is designed to preserve and enhance individual wealth in every conceivable future economic environment. Like the armored little creature from which it gets its name, the Financial Armadillo Strategy is both offensive and defensive in nature. It adapts to a wide range of investment climates and promises to endure, whatever economic upheavals may be on the horizon. The armadillo has survived since prehistoric times. Armadillo-strategy investors will be among those to survive what could truly be a tumultuous economic future.

The primary objective of any capital-preservationoriented investment program is to grow financial assets at a rate greater than inflation with nominal investment risk. Historically, US Treasury bills have been the single best vehicle for achieving this goal. Because T-bills, like all US Treasury securities, are backed by the "full faith and credit" of the US government, there is virtually no capital risk. As long as Uncle Sam is alive and kicking, your principal and interest are guaranteed. Except for a seven-year stretch between 1973 and 1980—a period of rapidly accelerating inflation—Treasury bills have provided an inflation-adjusted real rate of return. Consequently, the 90-day T-bill yield is a yardstick against which all conservative investment programs are measured.

A conservative investor could buy nothing but T-bills and be financially secure in a deflationary or stable-inflation economy. However, if runaway inflation is in the cards, T-bill investors run the risk of a yield that lags behind inflation, as was the case from 1973 to 1980. The challenge is to find an investment portfolio mix capable of matching the Treasury-bill yield while at the same time offering a long-term hedge against accelerating inflation.

The Financial Armadillo Strategy achieves this objective with a portfolio consisting of 4- to 7-year T-notes (another type of US Treasury security) and gold. The yield on 4- to 7-year T-notes is generally higher than that offered by 90-day T-bills. For example, today 5-year T-notes are yielding approximately 11 percent, compared to the 8 percent provided by 90-day T-bills. If you were to buy $20,000 worth of T-bills yielding 8 percent, you would receive a $1,600 return on your investment in a year, assuming a stable T-bill yield over the year. For $15,000 invested in 5-year T-notes yielding 11 percent, you would receive a comparable $1,650 return.

Due to the longer maturity of the 5-year T-notes, "purchasing-power" risk is increased. If the inflation rate goes from 4 to 15 percent in the 5-year maturity period of the T-note, you could expect a negative inflation-adjusted return. However, if you use the $5,000 saved in purchasing 5-year T-notes instead of T-bills to buy gold as inflation insurance, you could probably count on a positive real return even with soaring inflation.

During the inflation wave of the '70s—at the same time T-bill yields were lagging behind inflation—gold went from approximately $42 per ounce to over $800. I doubt if we can expect such a dramatic run-up during any future inflationary wave, but it is fair to assume that the price of gold would react favorably to a return to double-digit inflation. This 25 percent portfolio position in gold would more than compensate for the negative inflation-adjusted return on 5-year T-notes.

During a deflationary crisis, it is open to question whether the price of gold would decline. If investors are frightened in any extreme economic environment, inflationary or deflationary, gold might hold attraction. However, let's assume that gold does drop with deflation. T-notes would appreciate sharply as interest rates collapsed, producing substantial capital gains in addition to yield—something T-bills don't offer.

Let's consider what you could expect from the Financial Armadillo Strategy in a relatively stable disinflationary environment such as we are now enjoying. The yield on T-notes, assuming inflation and interest rates remain stable for the next five years, would retain approximately the same market value. The T-note portion of a portfolio would provide a rate of return substantially above the rate of inflation and comfortably above the T-bill yield. While the price of gold could conceivably go down, I'm confident it wouldn't drop far below its current price, a price consistent with my historical value guidelines.

The Financial Armadillo Strategy is as easy to implement as it is effective. T-notes can be purchased through your local commercial bank or stockbroker. (They are generally sold in minimum denominations of $5,000.) Gold coins can be easily purchased at numerous dealers and stored in a safe-deposit box at your bank. Certificates of gold ownership are also available at major banks throughout the United States. (Do not buy gold shares for your Financial Armadillo program. A gold share represents nothing more than a fractional interest in a hole in the ground, vulnerable to any number of natural or political disasters.)

It's not easy for individuals to ignore the often emotional advice given by financial pundits on either side of the inflation-deflation issue. Even an extremist can, on occasion, be correct, and those who follow such advice can make a quick killing. However, when extremists are wrong, their disciples can be wiped out. It's better to be safe than sorry. The Financial Armadillo Strategy offers a common-sense way to deal with the unknown.

Richard Young is president of Young Research & Publishing, Inc., and managing director of Newport International Investments, Inc. He is the publisher of Young's World Money Forecast, The Young Forecast, Young's International Gold Reports, and Young's Economic Strategy Reports.