Growing a hedge against inflation
Only a few months ago it was all the rage to fear the end of the financial world as we know it. A popular nightmare scenario featured a deflationary spiral -- a devastating cycle of declines in prices and wages.
Now that the economy is showing signs that it may actually recover, thanks in part to the federal government’s massive campaign of fiscal and monetary stimulus, many economists are worried that devastating inflation, not deflation, is in our future.
That would be a challenging experience for investors, especially those who can’t even recall the 1970s, when prices last galloped out of control in this country.
“People who are older have a memory of what it was like,” said Angela Bordwell, owner of Thrive Financial Alliance, a financial planning firm in Los Angeles. “But younger people, who don’t know what to expect, are nervous about it.”
Inflation has not yet reared its head, however, and there is no consensus about when it might. In fact, the consumer price index is down 1.3% in the last year, largely because energy and food prices plunged after peaking last summer. And some analysts expect consumer demand to remain weak for years, holding inflation in check and making lower prices the trend to worry about.
But if you believe that the economy is on its way to righting itself and that severe inflation may be the cost of recovery, you might want to think about which sorts of investments could serve as a bulwark of your portfolio. It’s possible, experts say, to hedge against rising prices by choosing assets that are resistant to inflation or can even benefit from it. Here’s a rundown of what to consider:
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Bond trouble
You might think of U.S. government debt as the safest investment around, and long-term Treasury bonds are indeed a great hedge -- against deflation. But heavy-duty inflation does a number on anyone who owns them, with their interest payments remaining fixed while the cost of living surges. And because higher inflation can sharply boost market interest rates, the market value of Treasuries can tumble in a rising-price environment. Other long-term bonds, including corporate and municipal debt, can suffer a similar fate.
If you already own long-term bonds, shifting into shorter-term debt, such as Treasury bills, or even into bank savings accounts will reduce your exposure to the ill effects of inflation, said Richard Barrington, an analyst at MoneyRates.com.
Some banks are offering interest of 2% or more -- not much, but better than the next-to-nothing returns of T-bills.
“It lets you keep your powder dry while you wait for a better environment,” Barrington said, “and you can earn a little bit of interest in the meantime.”
Still, any “cash” investment such as T-bills, bank accounts and money market mutual funds exposes you to a loss of purchasing power as prices rise.
A much stronger hedge against inflation: Treasury Inflation Protected Securities. These bonds, known as TIPS, pay a fixed interest rate just like standard Treasuries do. What makes TIPS different is that the government adjusts their principal in tandem with consumer prices. Thus your regular interest payments will rise along with the cost of living.
The increased principal is real: You get the whole amount when the bonds mature. And TIPS investors are protected somewhat in the event of deflation as well: The value of the principal can’t drop below the original face amount.
Despite more inflation talk in recent months, there was no rush into TIPS in the second quarter. Mutual funds that invest in inflation-protected bonds gained on average only 1% in the period, after surging 4.2% in the first quarter, according to Morningstar Inc.
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Hard assets
During inflationary periods, many investors turn to commodities such as oil, copper and grain because their value tends to rise along with consumer prices.
If rocketing energy prices are driving up the cost of living, having an investment in that industry can help offset those higher prices. Ditto with supermarket prices and agricultural commodities. Such focused investing is easy enough to do thanks to low-cost exchange-traded funds and other mutual funds that specialize in specific commodities.
But be aware that commodities can stagnate. Consider gold, for example. The precious metal tends to get bid up sharply when investors fear inflation. By the time you get in, the price gains may be all but over.
“Gold is already up 220% this decade,” Barrington said. “Just how much inflation do people think we’re going to get?”
And because commodities themselves don’t have earnings or pay interest, they can be dead money for a long time once inflation cools. Gold, for instance, began an extended slump after peaking in 1979-80, and its price didn’t revisit that level for more than a quarter of a century. If you can’t resist gold, think about investing in companies that mine it and thus have an earnings stream that can cause their stock prices to appreciate.
Stocks of companies that produce commodities can be nearly as volatile as the commodities themselves. Mutual funds that hold natural-resource stocks soared 21.5% on average in the second quarter, compared with 16.8% for the average domestic stock fund.
To minimize the risk from investing in a single commodity, many investment advisors suggest commodity index funds, which are designed to track a particular index of commodities.
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Stocks
Stocks can be good investments in times of rising prices. That’s because inflation allows many companies to raise their prices, boosting their earnings -- and their share prices.
“Keep a good portion of your long-term money in equities, because they will always outpace inflation,” Bordwell said.
But some sectors, such as energy and healthcare, can raise prices more easily than others, said James Dunigan, managing executive at PNC Financial Services Group Inc.’s wealth-management unit in Pittsburgh. So those sectors could benefit
Another way to play inflation is to invest in companies that ship goods abroad. The reasoning: If inflation in this country is greater than inflation in other major economies, that could push down the value of the dollar against other currencies. That helps U.S. exporters in two ways: Their goods become relative bargains abroad, and the value of their foreign sales in dollar terms increases.
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Bottom line
One of the most important things to understand about periods of steep inflation is that they have beginnings and ends. If you turn your portfolio into one big inflation hedge, you’re bound to lose out after prices start to level off.
With that in mind, Dunigan advises devoting no more than 10% or 15% of your holdings to inflation-resistant investments.
“If inflation is coming, hedge against it,” he said, “but don’t rip your portfolio apart.”
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Mutual Fund Quarterly Report
Treasuries
The value of long-term U.S. government bonds plunged for a second straight quarter as more investors felt confident enough about the financial system and the overall economy to move money back into riskier bonds and stocks.
Real estate
Property funds surged 30.2% in the second quarter on hope for a timely end to the recession. But the sector is down sharply over the last three years. And many analysts say the worst for commercial real estate is still to come.
Foreign stocks
Global stock markets soared, often surpassing Wall Street. Emerging markets did especially well. In some markets, stronger local currencies made returns in dollar terms even higher. Brazil’s market returned 48% for U.S. investors.
Corporate bonds
The revival of optimism and risk-taking that caused a powerful rally in stocks also sent the market value of corporate bonds up sharply, especially lower-rated “junk” debt. Funds holding higher-rated, long-term issues returned 10.9%.
Technology
Funds specializing in shares of tech companies gained 20.7% in the second quarter as investors figured such firms would benefit disproportionately from a rebound in the global economy. Telecom funds returned 23.5%.
Bear funds
So-called short-selling portfolios, which tend to move in the opposite direction of the overall stock market, recorded the worst performance among all stock-fund categories, plunging 20.2% in the quarter.
