It's beginning to look a lot like inflation. Or is it? Statistics seem to tell the story, but when it comes to inflation, not everyone agrees how the plot will unfold.
If you follow government reports, inflation has been tame for some time. The rate was just 1.4% in 2010, and Morningstar's Ibbotson Associates says that brings the annualized rate down to 2.2% for the past five years, 2.3% for the past 10 years, 2.4% for the past 15 years and 2.5% for the past 20 years.
Fed Chairman Ben Bernanke forecast in April that inflation this year will be no more than 2.8%. Intermediate term, through 2013, as well as long term, the Fed sees inflation at less than 2% a year. Market participants apparently expect inflation to be only slightly higher. Ten-year Treasuries were yielding 3.3% recently, and 10-year Treasury Inflation-Protected Securities were yielding 0.7%, implying that the inflation rate for the next 10 years is anticipated to be the difference: 2.6%.
Some observers beg to differ, however. "For some, the concern is that monetization of the U.S. debt via quantitative easing [by the Fed] will lead to inflation and higher interest rates," says Theo Gallier, chief investment officer at Private Ocean, a wealth management firm in San Rafael, Calif. "The belief is that higher inflation will be partially due to a falling dollar, which will result in higher prices for imports."
Higher inflation already is here, some advisors assert. "There is certainly a large degree of inflation out there right now, it just isn't in the government numbers," says Tony Welch, co-founder of Sarasota Capital Strategies in Osprey, Fla. "Just look at the change in commodity prices over the past year."
As Susan MacMichael John, president of Financial Focus, a financial planning firm in Wolfeboro, N.H., puts it, "We are always worrying about inflation. Many people are struggling with heating oil, grocery and gasoline prices, especially in a low-yield environment."
PRICES IN PERSPECTIVE
Yet as Gallier sees it, inflation is not certain to soar. "In our firm's most recent newsletter, we wrote: 'There is a tendency to create in our minds the following link: News out of North Africa and the Middle East leads to higher oil prices, which leads to higher inflation, which leads to lower portfolio values. This simple connection doesn't capture the complexity of the capital markets and cannot be used to ensure investment success.' "
That passage could be revised to describe a broader concept, Gallier notes. "You can say that there is a tendency to believe that a macroeconomic event leads to higher inflation, which results in higher interest rates and lower portfolio values." But he adds that the connection is simplistic, and following it is no sure path to investment success.
Gallier points to research published in 2010 by the Federal Reserve Bank of St. Louis. It concluded that doubling or tripling a country's monetary base does not lead to high inflation if the public views the increase as temporary and expects the central bank to maintain a low-inflation policy.
"This report offers evidence that large amounts of sovereign debt do not automatically lead to higher inflation," he says. "At our firm, we think the inflation rate will increase, although we seriously doubt that it will reach 1970s levels. We don't make macroeconomic forecasts, and we don't believe anyone can consistently get it right."
Of course, in the 1960s, few people thought inflation would reach the levels of a decade later. Macroeconomic forecasts are as subject to error as weather forecasts, and Gallier says there's certainly a chance that the inflation rate between now and 2021 will top 2% or even 2.6%.
"An expected inflation rate of around 2.5% is now baked into all asset classes," says Rick Ferri, founder of Portfolio Solutions in Troy, Mich. "If you believe inflation might be higher, you can hold assets that may hedge against rising prices."
To do so, one strategy is to see what worked in the past. The Ibbotson numbers show the peak period of recent inflation occurred from 1973 through 1981, when prices rose by 9.2% a year. During those nine years, small-cap stocks surged 18.8%, Treasury bills gained 8.2%, intermediate-term government bonds grew 5.9%, large-cap stocks gained 5.2%, and long-term corporate bonds and long-term government bonds both returned 2.5%, all on an annualized basis.
During the same period, median home prices more than doubled. Including reinvested dividends, the FTSE Total Return Equity REIT Index rocketed to 305 from approximately 110. Oil prices went to $35 in 1981 from around $3 a barrel in 1972. The total return on the S&P Goldman Sachs Commodity Index was 195.8%, or an annualized return of more than 12%. And gold prices went to nearly $400 an ounce from around $65.
Do results from 30 or 40 years ago offer guidance for hedging inflation now? Is it time to load up on small-caps, real estate, oil and other commodities while avoiding long-term bonds? Many say the short answer is no, because yesterday's lessons are tempered by today's realities.
As the Ibbotson numbers show, small- caps far outperformed large-caps during those inflationary years. "The problem with just using that historic time period is that it does not reflect the current valuation of asset classes," says Chris Cordaro, CEO of RegentAtlantic Capital in Morristown, N.J. "Small-cap stocks are widely overvalued now, making it very difficult to project how you would make money there over the next few years."
Linda Campbell, a senior financial planner with Budros Ruhlin & Roe in Columbus, Ohio, agrees. "Small-cap stocks, especially small-cap value stocks, have become more expensive from a valuation perspective relative to larger- capitalization stocks." Indeed, Cordaro says that "large-cap stocks are probably the best value out there right now."
According to Ferri, stocks can be the best long-term inflation hedge. "It's true that large-cap stocks went nowhere in the 1970s," he says. "However, stocks went up in the 1980s after inflation went down. Companies raise prices during a period of inflation, so profits may go up when inflation falls."
For exposure to commodities and natural resources, Ferri says many investors need look no further than their own equity portfolios. "People don't realize how much exposure they have if they invest through stock funds," he says. "I'd rather own companies in the commodities business than the actual commodities. The companies know their markets better than I do - for instance, ExxonMobil knows when and how to hedge energy prices."
As the data shows, intermediate-term bonds outperformed long-term bonds from 1973 to 1982, and cash did even better, nearly keeping up with the inflation rate. The comparison between then and now is complicated by the introduction of TIPS, government-issued bonds designed to deliver higher returns if inflation accelerates.
"The yield on nominal fixed income is composed of a real interest rate and an expected inflation rate," Gallier explains. "TIPS react to changes in actual, not expected, inflation. To hedge against the possibility that investors in nominal Treasuries are wrong about future inflation, add TIPS to the portfolio."
TIPS are tax-inefficient and should be held in an IRA or other tax-exempt account, if possible, he notes. TIPS held in a regular account generate income tax each year on principal accretion that's not collected until the bond matures.
John likes to buy TIPS directly at the five- and 10-year auctions to build a ladder in clients' tax-deferred accounts. "This is a nice, conservative way to put a client's mind at ease about inflation," she says. Depending on the client, she allocates 10% to 15% of a portfolio to TIPS. Over the last two or three years, the allocation has moved to 10% to 15% from 5% to 10%, partly as a response to market uncertainties and client worries about the market's ability to keep up with inflation.
Welch is leery of bonds right now. "The only bond exposure we currently have is in the high-yield area, and even that holding is on a short leash at this point," he says. "We are avoiding interest-sensitive items such as other bonds and utilities. Interest rates, which have been kept artificially low by the Fed, have nowhere to go but up."
This asset class, which did well from 1973 to 1982, drew mixed reviews after the boom and bust of the last decade. Cordaro lumps REITs with small-cap stocks as an extremely overvalued asset class. John, though, is comfortable with real estate. "We find real estate attractive at current valuations, even with last year's run-up," she says. "We use funds, ETFs and the real asset. Many of our clients who are entrepreneurs have several rental properties, both commercial and residential. There are some nice tax advantages for direct investments."
John suggests a conservative approach to rental properties now. "We recommend low leverage so that cash flows are positive in times like these, when there has been downward pressure on residential rents in some areas," she says. "However, direct real estate investing is not for the faint of heart, especially in states that are not particularly friendly to landlords."
The price of oil rocketed during the various energy crises of the 1970s, driving up commodity indexes. Oil spiked earlier this year amid turmoil in the Middle East and North Africa, but some advisors still consider energy and commodities good choices for hedging inflation.
At Capital Management Group in Washington, founder Bill Brennan carries both iShares Dow Jones U.S. Oil Equipment & Services Index ETF and SPDR S&P Oil & Gas Exploration & Production ETF in clients' portfolios. "It seems logical that they will perform well as the expanding global economy demands more energy," he says.
An investment in two ETFs dedicated to one area - oil and gas drilling, and services - is unusual for Capital Management Group, Brennan says. "We were motivated both by their potential as an inflation hedge and as a potential source of shorter-term profits. Every Monday we review our decision to continue holding these funds, which is something we don't do as intensely with most of our other positions." His firm limits client holdings to a maximum of about 5% in any individual sector fund.
Welch's firm also holds SPDR S&P Oil & Gas Exploration & Production ETF. "Exploration will go on, as the need for oil and gas continues. I like having exposure to natural gas, where prices are finally starting to go up," he says.
In addition, Welch has a position in Elements Rogers International Commodity Index-Agriculture Total Return ETN. "The index linked to this ETN was provided by Jim Rogers, the well-known commodities trader," he says. "It's a truly international index, including commodities not included in the usual indexes, such as rubber, rice and wool. This provides more diversification for investors." Welch's clients now have 7% to 8% of their portfolios in this ETN, along with 6% in the oil and gas ETF.
For even more commodity exposure, Welch also has a 10% allocation to emerging markets ETFs. "Many emerging markets are commodity-based," he says. "That's true for Brazil, South Africa and Russia, for example." Other emerging markets such as China and India are better known as commodities consumers; growth there probably will increase demand and prices.
From 1973 to 1982, gold rose along with oil and real estate, but the recent surge in precious metals has created caution. "Gold may give investors psychological comfort in times of economic distress, as seen in the new highs reached since the fall of 2008, but we believe it is not a good bet for the long term," Gallier says.
Others disagree. "Gold, which is the only way to protect your assets in the coming currency crisis, can act as an inflation hedge," says Arnie Waters, managing member of A.L. Waters Capital in Braintree, Mass. Supply is limited, and labor issues in South Africa may constrain production. Waters believes gold could hit $1,700 an ounce by this summer and $2,500 in the long term.
Like gold, many investments that protected against inflation seem expensive now. But experts say that planners reluctant to buy at what seems like peak prices might gradually build positions in desired asset classes, growing hedges without getting trimmed.
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