From the August 2011 issue of Research Magazine • Subscribe!

How Bad Will Inflation Get?

During the 2008 credit crisis, asset prices fell and the prospect of a general deflation was the biggest worry. Today, deflationary fears are still present but so is the threat of out-of-control inflation. Will inflation become public enemy number one? How bad will it get? Let’s evaluate these questions.

Measuring Inflation

The Consumer Price Index for All Urban Consumers (CPI-U) is a closely followed indicator that benchmarks the average change in retail prices for a basket of over 200 categories of assorted goods and services. Changes in the CPI affect Social Security payments of more than 50 million Americans along with recipients of food stamps. While it isn’t the only inflation yardstick, the CPI is arguably the broadest and most influential measure of nationwide inflation.

“There were numerous changes made to how CPI is determined in the 1980s and 1990s,” states Daryl Montgomery, author of Inflation Investing: A Guide for the 2010s. “All of these changes lowered the reported inflation rate. If the CPI number is calculated the same way over time, a very different recent history of inflation emerges. Inflation was actually around 13 percent at the commodity peak in 2008.”

The May CPI figures showed a gain of 3.6 percent over the past 12 months, before seasonal adjustments. Other subcategories like the energy index increased 21.5 percent and the food index has risen 3.5 percent. All of these figures have been rising in recent months.

Broadly diversified commodities are confirming the trend of higher prices too.

The GreenHaven Continuous Commodity Index Fund (GCC) is ahead by 34.75 percent over the past year. GCC follows an equal-weighted index of 17 commodities that are averaged across the futures curve six months out. The fund has significant exposure to grains, livestock, energy and soft commodities. In addition, GCC is rebalanced each day in order to maintain each commodity’s weight as close to 1/17th of the total as possible.

Even with a recent pullback in gasoline and food prices, commodities are higher compared to early 2010.

“Many people tell me they are buying cereal and Triscuits, paying the same price per unit — but noticing the box sizes have shrunk. And the free prize in the cereal box? Certainly, that is just a childhood memory,” notes Joseph G. Witthohn, CFA with the Investment Strategy Group at Janney Montgomery Scott.

It’s the Dollar

With the dollar slumping, more people are finally making the connection to this particular trend and more expensive goods. Since nearly all major commodities are priced in U.S. dollars, declines in the dollar will automatically make commodities more expensive. And the increasing number of new dollars printed continues to dog the dollar’s recovery.

“Inflation in the 2000s will be much worse than in the 1970s because the current amount of money printing is way beyond anything that happened back then,” argues Montgomery. He projects there will be up to a 10-year lag from when the maximum amount of monetary stimulus takes place and the peak inflation rate. He thinks a 100 percent price rise in three years or less is a real possibility.

While it’s difficult to foresee whether inflation will surge that much, it’s a far cry from what the Federal Reserve expects. The Fed projects inflation of less than 2 percent for each of the next three years. At the same time, Fed Chairman Ben Bernanke acknowledged the danger of inflationary pressures. In his testimony to Congress earlier in the year he admitted, “Sustained rises in the prices of oil or other commodities would represent a threat both to economic growth and to overall price stability.”

Portfolio Strategies

What’s the best way to build an investment portfolio for the threat of higher inflation? “Ultimately, hedging inflation’s risk over time requires using a mix of assets, since any one asset class has its own set of pros and cons as a defense against inflation,” says Jim Picerno, editor of CapitalSpectator.com and author of Dynamic Asset Allocation.

Let’s analyze a few ETF strategies that hedge against inflation.

Dividend Paying Stocks

If equity returns aren’t going to be as high as before, that means dividends will play a larger role in the total return that investors receive. In this regard, investing in stocks with rising dividends is the way to capitalize. “A good way to invest this way is by purchasing ETFs that only own stocks with a long history of rising dividends, says Witthohn.

Two ETFs that fit this description are the Vanguard Dividend Appreciation Fund (VIG) and SPDRs S&P Dividend ETF (SDY). VIG is based on the Mergent Dividend Achievers Index, which buys U.S.-based stocks that have raised dividends for at least 10 consecutive years. SDY follows the S&P High Yield Dividend Aristocrat Index, which focuses on stocks that have raised dividends for at least 25 consecutive years. VIG charges annual expenses of 0.23 percent while SDY charges 0.35 percent.

Commodities

Another way to hedge against higher inflation is by investing in a basket of commodities using diversified commodity ETPs like the previously mentioned GreenHaven Continuous Commodity Index Fund (GCC). Advisors wanting to focus on a specific segment of the commodities market such as precious metals can use the ETFS Physical Precious Metals Basket (GLTR). By holding gold, silver, platinum and palladium, GLTR takes the guesswork out of trying to figure out which particular metal to purchase.

“Commodities in general are the traditional inflation hedge, gold and oil/energy in particular, but you have to be careful since when you buy commodities can make a big difference,” says Picerno. He cites buying gold in the early 1980s, for instance, when it was near $800 and nosedived shortly thereafter. It’s a sober reminder that conventional inflation hedges don’t always live up to their reputation.

Witthohn adds: “I find it difficult to determine how much of the recent run-up in the price of gold has already factored future inflation into it and, while holding precious metals makes sense as a diversifier, it should only be a moderate portion of a portfolio.”

Commodity Sectors

Equity sectors closely linked to commodities offer a good alternative for advisors not comfortable with buying physical or futures based commodity ETPs. The Materials Sector SPDR (XLB), Energy Sector SPDR (XLE) and Market Vectors Gold Miners ETF (GDX) are all excellent choices.

For a broader equity play on commodities, see the Market Vectors-RVE Hard Assets Producers ETF (HAP). It contains a global universe of stocks engaged in agriculture, energy alternatives, base and industrial metals, energy, forest products, and precious metals.

Inflation-Linked Securities

Government securities that adjust upwardly according to inflation are another way to hedge. Many advisors have traditionally used U.S. Treasury Inflation-Protected Securities, or TIPS (TIP), but concerns over the U.S. government’s rising credit risk means advisors should look at international or global TIPS.

“Inflation-linked bonds from foreign countries operate much like U.S. TIPS,” says Matt Tucker iShares head of fixed income investment strategy at BlackRock.”While the calculation for adjusting principal and interest varies between countries, the concept is the same: the bonds are indexed to local consumer price indexes in order to help protect investors from the negative effects of inflation.”

BlackRock recently launched the iShares Global Inflation Linked ETF (GTIP) and the iShares International Inflation-Linked ETF (ITIP). GTIP follows the BofA Merrill Lynch Global Diversified Inflation-Linked Index and provides exposure to global inflation-linked bonds in France, Italy, Brazil, the U.K. and U.S. ITIP is benchmarked to the BofA Merrill Lynch Global ex-US Diversified Inflation-Linked Index and carries exposure to France, Italy, Australia and Brazil, among other countries. It can be paired with iShares Barclays TIPS Bond Fund (TIP) as part of a global inflation-linked bond strategy.

“Just as investors use U.S.TIPS to help protect domestic portfolios against inflation, they should consider using global inflation-linked bonds to help protect their global portfolios,” adds Tucker.

Helping Clients Prepare

“Don’t overlook cash and cash equivalents, such as T-bills,” says Picerno. At first glance, there’s nothing that looks like an inflation hedge here. But imagine you have an allocation to cash and inflation soars over the next three years. Yes, you’ve suffered an opportunity cost. But once higher inflation has arrived, current yields on bonds are likely to be substantially higher. “That’s good news if you’re sitting on cash, since you can move the money into high-yielding fixed-income investments, perhaps locking in hefty real yields for years to come.”

While there may never be a perfect hedge against inflation, the time to prepare you clients’ portfolios for the destructive forces of inflation is before it becomes a major problem, not after. Given the backdrop of hints, call your clients to do a portfolio checkup to make sure they’re full hedged. As with anything, there will be those who are victimized by inflation and those who can profit from it. •

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