With inflation worries> spreading, investors are scrambling to find smart ways to protect their purchasing power. But it's harder than it's been in years past, some financial advisers warn: Some of the so-called traditional inflation hedges may not hold up so well this time around.
Investors have already been piling into some of the most stalwart inflation hedges. Gold is up 22% in the last 12 months, and investors added $1.75 billion to precious metal mutual funds and exchange-traded funds during the last quarter of 2010, up 12% from a year earlier, according to Morningstar. In January, investors had about $616 billion in TIPS, up 9% from a year earlier, according to the Treasury Department. "Investors have been putting their money in there to protect from inflation," says Chris Cordaro, chief investment officer at RegentAtlantic, a wealth management firm.
Why are investors so jittery? After all, just last week Federal Reserve chairman Ben Bernanke said in Congressional testimony that that overall inflation in the U.S. is low and "longer-term inflation expectations have remained stable." But doomsayers cite several worrisome factors, including the Fed's latest round of quantitative easing and rising energy prices. Also, soaring food prices in many emerging markets is heightening fears those cost increases will soon extend to other goods and services and eventually hit our shores.
Whatever happens, experts agree it will be markedly different from the last real inflationary period in the early 1980s -- mostly because the economy is healthier now. With interest rates close to zero, the Fed has a lot more room now to increase rates slowly without choking off borrowing and economic growth. In addition, corporate earnings are stronger this cycle -- making equities a good bet -- and tax rates are generally lower, which means companies and individual investors can put more of that cash to work.
Of course, even this relatively good news doesn't make picking inflation busters any easier, says Cordaro: "Just about every traditional inflation hedge is selling at high valuations."
SmartMoney looked at five traditional inflations and why they may or may not work if inflation hits home.
Blue chips have been a safe bet during previous inflationary periods: During the 1970s, the top 10 dividend-paying stocks on the Dow Jones Industrial Average returned 6.53% more on an annual basis than the rest of the index, according to data compiled by MFS Investment Management. And there's good reason to believe they'll outperform again, says Michael Cuggino, president at Permanent Portfolio Family of Funds, a mutual fund family. Here's why: Dividends tend to keep up with inflation because many large companies can pass the rising cost of raw materials on to consumers by raising prices. Also, increased demand for goods in the U.S. and abroad should boost profits and returns, says Cuggino.
Even for retirees, dividend-paying, big company stocks may now better sources of retiree income than bonds, says financial planner Frank Fantozzi. With inflation, he says, the risk of losing purchasing power is higher than the risk of losing principal.
Treasury Inflation-Protected Securities
Treasury Inflation-Protected Securities (TIPS)
Treasury inflated-protected securities are often used as a way to protect investors from inflation since the principal value of the bond moves in step with the consumer price index. But over the past few months, as jittery investors have piled into TIPS, their yields have fallen. Right now, 10-year TIPS yield around 1.3%, relative to 3.6% for nominal 10-year bonds, a spread that forecasts an average of at least 2.3% inflation per year over the next decade.
This means TIPS are relatively overvalued, says Francisco Torralba, economist at Ibbotson Associates, a Morningstar company. Generally, 10-year TIPS become profitable when CPI passes 2%, says Cordaro. And in December, CPI still stood at just 0.2%, according to the Bureau of Labor Statistics.
Real estate investment trusts have historically offered good protection against inflation because inflation lifts the rents these trusts collect and pay to shareholders as dividends. But in this market, yields on REITS have fallen because investors rushed into the sector the value of U.S. REITs increased by 43.5% in 2010 and inflation could exceed the amount of the dividend distribution, says Jeff Sica, president at Sica Wealth Management. The Vanguard REIT index has doubled in price in two years and now yields barely more than 2%. For an investor getting in now, "REITS are so overvalued I find it difficult to see how you'll make money over the next five years," says Cordaro.
Investors who want to use real estate as a hedge and can afford it should instead look to buy a multi-unit property to take advantage of relatively low prices that could appreciate during inflation or will at least grow in the long term, says Sica. Also, should inflation occur, rents will increase, possibly leading to bigger cash flows. This is especially true for an investor who locks in a fixed-rate mortgage now since this loan will be cheaper when interest rates rise. On the flip side, investors could still see property values drop as the housing market continues to recover.
Oil is a natural hedge against inflation partly because oil companies can pass on any rising costs at the pump. Inflation has already started to hit the sector: In December, energy prices rose 4.6%, according to the Bureau of Labor Statistics, while food prices rose by 0.1%. And investing in oil company stocks and oil ETFs can still provide inflation-protection and decent returns, says Sica. The shares of major oil companies typically rise during times of higher gas prices. The price of oil has risen 75% since 2005; in the same time period, Exxon Mobil is up 61% and Chevron is up 102%. There's still room for these companies to grow in part because they benefit from higher oil prices as do ETFs with exposure to oil production, he says. For example, iShares Dow Jones U.S. Oil & Gas Exploration and Production Index Fund (IEO)
But this time, investors might want to stay away from oil futures. There is more risk here, partly because the investor is on the hook for oil to hit a certain price during the contract period. Plus, growing speculation of rising oil prices to come has pushed the price of futures oil contracts higher than current prices. "You're starting at a big deficit that's hard to beat," says Cordaro.
Investors seek out the precious metal to protect against currency instability. But this time around gold won't provide much of a hedge, at least not if the Fed starts to raise the federal funds rate, says Jim Swanson, chief investment strategist at MFS Investment Management. Once that happens, banks will raise their rates on money market accounts (currently around 0.7%) and certificates of deposit (around 1.1% for a one-year CD) will follow. Once these yields start rising beyond 2%, which could occur by the end of 2011, expect more investors to cash out of gold and return to traditional bank accounts, says Swanson. That's also because it's expensive to hold gold, whether it's bars in a safe deposit box or in ETFs that charge expense ratios to cover costs, which may include insurance and storage.
But, investors who are worried about the dollar can consider metals and mining stocks, says Swanson. According to data compiled by MFS, an investment management firm, this sector has a 60% correlation to inflation, making it one of just a handful of industries where stocks rise with inflation. "If people are willing to pay more for those metals, the stock goes up because profit margins expand," he says. In this environment, mining companies aren't a sure of a bet, given exaggerated investor demand, but investors should focus on companies with mining costs below the industry average and a strong growth profile, says Min Tang-Varner, who covers gold stocks at Morningstar. She recommends Canadian gold miners Yamana Gold (AUY)