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Strategies for investing as inflation looms

MUTUAL FUND QUARTERLY REPORT

There's no consensus on when it might occur, but inflation could be the price of recovery. Here are ways to hedge by picking assets that are resistant to inflation or can even benefit from it.

July 12, 2009|Steve Garmhausen

Only a few months ago it was all the rage to fear the end of the financial world as we know it. A popular nightmare scenario featured a deflationary spiral -- a devastating cycle of declines in prices and wages.

Now that the economy is showing signs that it may actually recover, thanks in part to the federal government's massive campaign of fiscal and monetary stimulus, many economists are worried that devastating inflation, not deflation, is in our future.

That would be a challenging experience for investors, especially those who can't even recall the 1970s, when prices last galloped out of control in this country.

"People who are older have a memory of what it was like," said Angela Bordwell, owner of Thrive Financial Alliance, a financial planning firm in Los Angeles. "But younger people, who don't know what to expect, are nervous about it."

Inflation has not yet reared its head, however, and there is no consensus about when it might. In fact, the consumer price index is down 1.3% in the last year, largely because energy and food prices plunged after peaking last summer. And some analysts expect consumer demand to remain weak for years, holding inflation in check and making lower prices the trend to worry about.

But if you believe that the economy is on its way to righting itself and that severe inflation may be the cost of recovery, you might want to think about which sorts of investments could serve as a bulwark of your portfolio. It's possible, experts say, to hedge against rising prices by choosing assets that are resistant to inflation or can even benefit from it. Here's a rundown of what to consider:

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Bond trouble

You might think of U.S. government debt as the safest investment around, and long-term Treasury bonds are indeed a great hedge -- against deflation. But heavy-duty inflation does a number on anyone who owns them, with their interest payments remaining fixed while the cost of living surges. And because higher inflation can sharply boost market interest rates, the market value of Treasuries can tumble in a rising-price environment. Other long-term bonds, including corporate and municipal debt, can suffer a similar fate.

If you already own long-term bonds, shifting into shorter-term debt, such as Treasury bills, or even into bank savings accounts will reduce your exposure to the ill effects of inflation, said Richard Barrington, an analyst at MoneyRates.com.

Some banks are offering interest of 2% or more -- not much, but better than the next-to-nothing returns of T-bills.

"It lets you keep your powder dry while you wait for a better environment," Barrington said, "and you can earn a little bit of interest in the meantime."

Still, any "cash" investment such as T-bills, bank accounts and money market mutual funds exposes you to a loss of purchasing power as prices rise.

A much stronger hedge against inflation: Treasury Inflation Protected Securities. These bonds, known as TIPS, pay a fixed interest rate just like standard Treasuries do. What makes TIPS different is that the government adjusts their principal in tandem with consumer prices. Thus your regular interest payments will rise along with the cost of living.

The increased principal is real: You get the whole amount when the bonds mature. And TIPS investors are protected somewhat in the event of deflation as well: The value of the principal can't drop below the original face amount.

Despite more inflation talk in recent months, there was no rush into TIPS in the second quarter. Mutual funds that invest in inflation-protected bonds gained on average only 1% in the period, after surging 4.2% in the first quarter, according to Morningstar Inc.

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Hard assets

During inflationary periods, many investors turn to commodities such as oil, copper and grain because their value tends to rise along with consumer prices.

If rocketing energy prices are driving up the cost of living, having an investment in that industry can help offset those higher prices. Ditto with supermarket prices and agricultural commodities. Such focused investing is easy enough to do thanks to low-cost exchange-traded funds and other mutual funds that specialize in specific commodities.

But be aware that commodities can stagnate. Consider gold, for example. The precious metal tends to get bid up sharply when investors fear inflation. By the time you get in, the price gains may be all but over.

"Gold is already up 220% this decade," Barrington said. "Just how much inflation do people think we're going to get?"

And because commodities themselves don't have earnings or pay interest, they can be dead money for a long time once inflation cools. Gold, for instance, began an extended slump after peaking in 1979-80, and its price didn't revisit that level for more than a quarter of a century. If you can't resist gold, think about investing in companies that mine it and thus have an earnings stream that can cause their stock prices to appreciate.

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