Monday, January 23, 2012

2012 Theme: Inflation vs. Deflation

In the embedded video, "Bond King" Bill Gross discusses the outlook for inflation and deflation and shows why getting the right answer to this question is a major factor for investors: asset classes perform quite differently under "reflation" (increasing inflation), disinflation (lowering inflation) and deflation.

Mind you, most financial assets, both nominal and real, perform best under periods of falling inflation, the "30 fat years" described by Gross.  Under reflation, both nominal and real assets perform badly, but real assets perform much less badly, as they can "keep up" with rising prices, albeit slowly.  Finally, nominal assets do well in deflation and real assets do very poorly in deflation.  The problem for nominal assets (e.g. bonds) is default, which rises sharply and can lead to a permanent impairment of capital.

The real question is: which are we likely to have.  While Gross doesn't say - he makes it clear that the jury is still out - he does help to deconstruct the problem and lay out some of hte markers.

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