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June 20, 2006 at 08:00 PM
In response to signs of rising inflation in the U.S. economy, the Federal Reserve is widely expected to increase short-term interest rates in late June, leaving investors wondering how to battle higher consumer prices.
The Consumer Price Index (CPI) gained 0.4% in May, while the core rate of inflation (excluding food and energy) rose 0.3% — both figures came in above Standard & Poor’s expectations. “The stronger-than-expected pricing data will likely add to inflation fears, adding upward pressure to yields and holding down equity prices,” said David Wyss, Standard & Poor’s chief economist. “Year-over-year, the headline index accelerated to a 4.2% pace from 3.5% in April. Moreover, the core index accelerated to a 2.4% pace from 2.3% the month before.”
The annual inflation rate has been relatively low since the mid-1980s and never exceeded 5.4%. Dropping to a low of 1.6% in 1998, the inflation rate has been steadily ascending, reaching 3.4% in 2005.
Wyss said he expects the Fed to hike rates to 5.25% in June, and perhaps again in August to 5.50% — but he thinks these moves will have to be reversed next year. “The incoming data suggest that the economy is slowing more suddenly than we expected, but also that inflation is heating up,” he said. “The Fed is torn between these trends. We think the logical thing for the Fed to do is take June off and start looking at the data meeting by meeting.”
Wyss also noted that since inflation is a lagging indicator, the “actions the Fed has already taken will bring inflation down next year. Inflation will probably peak at the end of this year, with the core figure at about 2.5%.”
So, what are investors to do?
Investors have traditionally sought defensive equity sectors — such as consumer staples, utilities, materials, energy and health care — to fight inflation. Sam Stovall, chief investment strategist at Standard & Poor’s, notes that these industries tend to outperform the market during periods of rising inflation.
A more novel strategy to battle inflation may come from the fixed-income universe, particularly Treasury Inflation-Protected Securities, or TIPS, which are bonds issued by the U.S. Treasury Department. Launched in 1997, the U.S. TIPS market currently totals about $370 billion, representing a small portion of the total fixed-income universe, and approximately 9.5% of the total marketable nominal U.S. Treasuries outstanding.
Presently, there are a handful of mutual funds that primarily invest in inflation-linked bonds, as well as one exchange-traded fund dedicated to investing in TIPS — the $3.8-billion iShares Lehman TIPS Bond Fund (TIP). Introduced in December 2003, this ETF seeks to match the price and yield performance, before fees and expenses, of the Lehman Brothers U.S. Treasury Inflation Notes Index.
