No. Not yet. With increased government spending and deficits as far as the eye can see, many investors are concerned about protecting themselves from the type of roaring inflation that we experienced during the 1970s. We believe it is premature to position for inflation even though we agree that current policies, left unchecked, pose a real risk. These policies are designed to counter very weak fundamentals in the U.S. economy that otherwise point toward flat or decreasing prices (i.e., deflation). How these two forces collide will dictate the path of inflation.

Today, many of the major causes of inflation lie dormant. We have near-record levels of excess industrial capacity, which suggests subdued pricing pressures. Also, with official unemployment at the highest rate in decades and an underemployment percentage rate in the high teens, wage pressures are unlikely to be of concern over the next several years. Finally, the history of deleveraging cycles following periods of excess credit suggests that contracting credit creates a strong headwind to growth, while keeping a lid on inflation. Despite recent growth in gross domestic product, bank lending continues to contract at an alarming rate, beginning to unwind decades of credit growth. Because most investors have never lived through a deleveraging cycle, these forces are not well understood and may be contributing to a dangerous complacency.

Weakness in the economy is being countered by historically low interest rates and high levels of government spending. The U.S. deficit is projected to reach $1.5 trillion for 2010—an amount exceeding 10 percent of GDP. Highly simulative government policies can lead to too much money chasing too few goods, the classic definition of inflation. Yet massive government intervention has thus far merely served to partially mitigate the contraction in credit. At some point the policies will have their desired impact, but we have a long way to go to undo the economic damage.

Given near-term deleveraging pressures, but longer-term inflationary concerns, we advise clients not to abandon bonds. Although absolute bond yields are low by historical standards, their yields relative to inflation are still attractive. Furthermore, bonds will perform well if we tip into a deflationary decline since their purchasing power is not eroded by inflation. In contrast, equities fare poorly as the decreasing price of goods weighs on corporate earnings. We recognize the potential inflation risk, but we think it is several years off. We are incrementally preparing by building positions in commodity futures diversified among energy, metals and agricultural goods. This is the purest way to protect against rising prices. Despite headlines to the contrary, investors do not need to hurry to buy inflation protection. Instead, they should recall the investment truism that “when everyone expects something, it often does not happen.”