Investing: What to Do About Inflation and What Not to Do
Matthew Bandyk

 

American consumers have had plenty of things to worry about over the past year, but inflation has not been one of them. From the end of 2008 to the end of 2009, the consumer price index rose 2.7 percent, much lower than the 4.1 percent growth in 2007.

But many Americans are worried that prices will rebound--big time--in 2010. A December survey from the Conference Board found that consumers expect a 5.1 percent increase in general prices over the course of this year. Such a gain wouldn't be small potatoes. The CPI has not gone up by more than 5 percent in one year since 1990, when the Iraqi invasion of Kuwait caused the price of oil to spike. A strong uptick in inflation would be damaging to consumers, especially on the heels of a recession. To put it into perspective: "If inflation averaged 5 percent, that would cut your buying power in half in 14 years," says Greg McBride, senior financial analyst at Bankrate.com.

Investors also are getting jumpy: The price of gold, a traditional hedge against inflation, rose during the recession and rallied 24.8 percent against the dollar last year. "People are concerned about inflation, and that's why the price of gold has been going up," says Steve Hanke, an economist at Johns Hopkins University.

The main cause for that concern is the recent increase in government spending and the debt needed to finance it. The International Monetary Fund has predicted that without tax increases or major spending cuts, U.S. government debt will rise from about 94 percent of the gross domestic product this year to 108 percent in 2014. The theory is that massive amounts of borrowing tend to weaken the dollar's value by forcing the expansion of the money supply through increased issuance of U.S. treasury bonds and also by making foreign investors less likely to want treasuries.

Economists are divided about whether inflation will materialize. A survey of economists released last year by the National Association for Business Economics found that about 50 percent think the Federal Reserve Board will be able to keep inflation down over the next couple of years, while 41 percent think significant inflation is likely.

If inflation comes roaring back soon, the savings and investments of a great number of Americans will suffer because many have not considered inflation-hedging strategies, says John West, a director at Research Affiliates. The usual investment strategies often do not work when inflation is high. For example, many stocks tend to do badly with inflation because prices increase without an increase in value. Your stock portfolio is not worth as much in a high-inflation environment.

Preparing for inflation requires a look at assets whose value can resist a weakening dollar or rising consumer-good prices. "You want to invest in things with real tangible value," says Rich Toscano, a financial planner with Pacific Capital Associates. But common inflation hedges are not always safe bets. Here are three of the most common assets investors flock to when fears of inflation are high.

1. Treasury inflation-protected securities.

TIPS are one such hedge. These are government-issued bonds whose principal is tied to the inflation rate as measured by the CPI. While treasuries are usually seen as very safe investments, TIPS could be problematic for investors if the predictions of government debt weakening the dollar come true. "In most people's minds, they think of inflation going up across the board. That's oversimplified," says Toscano. "If there was to be a genuine global revulsion against treasuries, rates could go up more than inflation goes up." If foreign investors were to demand fewer treasury bonds, interest rates would most likely go up and the value of the dollar would drop. The CPI might not immediately reflect a fall in the value of the dollar stemming from a fall in treasuries, since general weakness in the economy or other factors could keep the prices of other goods down. Rising treasury yields would bring down the principal paid to the TIPS holder, but the CPI would not be rising at a fast enough rate to increase the principal.

2. Real estate.

Inflation hedging is all about assets with tangible value, and land is an obvious such asset. But housing prices do not always go up along with every type of inflation. For example, if inflation is driven by rises in oil prices, the cost of living would go up, but "that has no effect on home prices," says Toscano.

Like TIPS, real estate might not pay off if interest rates rapidly rise. "If you try to sell your house, you might be selling into a climate of high interest rates," says Toscano. Such a climate poses two problems for the home seller: First, housing prices might be declining. Second, the seller's pockets would be hit with a higher rate on the debt probably used to buy the home in the first place. The second concern is more important if you have an adjustable-rate mortgage rather than a fixed rate.

3. Gold.

Over the past few years, you have almost certainly seen commercials urging you to sell your gold jewelry. Other ads hawk gold as the ultimate safe investment whose values never decline. While the gold market might be hot now, it is no sure thing for the future. "Gold is an asset class that is historically very volatile," says West. It is also not a perfectly reliable inflation hedge. The price of gold is affected by supply-and-demand factors that often have nothing to do with inflation.

Like almost all forms of investing, inflation hedging requires diversification to avoid the volatility of any one asset. Beyond gold, volatility is a problem for commodities whose prices generally--but not always--track inflation. These include agricultural goods and oil. West recommends that investors looking to hedge against inflation consider safer alternatives: mutual funds that invest in a range of commodities or exchange-traded funds that track commodity indexes. After all, inflation could come in many forms. "It could be a ramp-up in food prices or a ramp-up in precious metal prices," West says.

Another asset that can be part of a diversified inflation-hedging portfolio is bank loans. Mutual funds that specialize in bank loans invest in short-term loans packaged and sold by banks at variable interest rates. "They actually have as high of a correlation with inflation as commodities do," says West.

Hedging strategies may gain popularity in 2010 as the signs of inflation down the road begin to appear. The economy might still look far from overheated, but as Americans have learned in recent years, fortunes can change quickly.

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Investing: What to Do About Inflation and What Not to Do | Matthew Bandyk

 

(c) 2010 U.S. News & World Report