Inflation Paradox

Inflation measures the increase in prices for raw materials and finished goods. A little inflation is a good thing, because it shows that there is decent demand for products, and an economy that's nicely "humming along" allows folks to pay more for stuff and not be adversely affected.

Runaway inflation is not a good thing, however. This scenario makes it very difficult for businesses to plan, since prices are rising so quickly it is hard to make long-range decisions. This introduces uncertainty--and since investors don't like big question marks, stocks tend to underperform during these periods (like in the 1970s).

A lack of inflation (namely, deflation) can be even worse. This type of environment can lead to a vicious cycle where a lack of demand from consumers (either because they are too scared to buy or because they don't have any money to spend) leads to lower prices, which in turn reduces corporate profits, leading to more layoffs and even less buying. This was last experienced in the second half of 2008. In that six-month period, commodities prices lost about 40% and consumer spending went into freefall. Demand for raw materials fell dramatically; in fact, natural gas prices fell to multi-year lows and there remains so much of it there is literally no storage left. Some analysts actually think natural gas prices could get negative!

Now that the economy has started to get back to normal, we have seen some recovery in raw materials prices. Commodity indices are up about 12% on the year; and crude oil, which dropped nearly 60% in price, has gained about two-thirds of that back.

It is this price rebound that is getting some investors nervous. At present, demand is too low for the price of goods to be passed along to consumers. However, 12 or 24 months from now inflation will make its inevitable return, due more to the cyclicality of the economy than to anything else. Here are a few ways advisors can respond to this scenario.

More stocks. Equities are historically one of the best hedges against inflation. Increasing high beta holdings, including more large-cap and tech stocks in the mix, makes sense as inflation rises.

Increase variable rate securities. Since interest rates tend to rise with inflation, ramping up variable rate exposure certainly makes sense. Likely additions include Treasury Inflation Protected Securities (TIPS). These government-backed bonds pay a coupon interest rate that is directly pegged to changes in the consumer price index (CPI), a direct measure of inflation.

Increasing credit exposure. Treasuries typically lose ground in rising rate environments. A good alternative is high quality corporate debt, which benefit as companies can benefit from an improving overall economy.

Ben Warwick (ben@qesinvest.com) is chief investment officer of Quantitative Equity Strategies LLC in Denver, and Memphis-based Sovereign Wealth Management, Inc.

See More of Ben Warwick's Portfolio Diagnostician Blog Posts

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