If it seems like your paycheck is getting smaller because the general cost of regular everyday purchases is getting higher, you may be wondering if the dreaded “I-word” is rearing its ugly head. That’s right–Inflation. Now that it is out in the open, we would like to set the record straight by explaining the effects of inflation and the steps you should take to grow your portfolio when inflation occurs.
Inflation Basics
Inflation is the rate at which the general level of prices for goods and services is rising; therefore, purchasing power is falling. During periods of economic growth, a 2% to 3% level of inflation is normal and expected. Keeping inflation within normal levels is one of the responsibilities of the Federal Reserve Bank. Typically, during periods of economic growth inflation is curtailed by the Fed raising interest rates. This tightens the money supply and keeps prices from climbing too fast.
However, currently our economy is recovering, and raising interest rates could slow or stall it, dampening our modest growth. High unemployment and continued declines in housing prices have given the Fed enough counter-inflationary data to refrain from raising rates; therefore, be prepared to endure a period of moderate inflation as the economy strengthens. Once recovered, interest rates can be raised to rein in inflation. In the meantime, businesses can only react to rising costs in a few ways. Unfortunately, in the long run the most common method is to pass higher costs on to consumers. As you have probably noticed, it takes more money to fill up your car every week. Groceries are slowly getting more expensive. Basic goods and services cost more and more, making it seem like we are entering an inflationary period.
Defending Your Portfolio
So how do you defend your portfolio? Henssler Financial commissioned a comprehensive market study of periods of high inflation. Based on that research, we have listed different classes of investments and methods to protect and grow your assets during this difficult time.
Bonds
A bond is a fixed-income security where an investor loans a principal amount to an entity for a specified period of time and at a set interest rate with interest payments occurring regularly, usually semiannually. During inflationary periods, bond values can diminish for two reasons—maturity date and interest rate. The further the bond is to maturity, the more sensitive it is to interest rate moves. If interest rates rise, as they typically do during periods of inflation, the value of the bond is more likely to decline. From 1900-2008 the real rate of return on bonds was slightly more than 2% in the United States. The real rate of return is equal to the rate of return minus inflation expressed as a percentage.
Strategy: Bonds serve as a means of diversifying a portfolio and reducing volatility. However, in an inflationary environment, yields tend to be smaller and risk is greater. If you must invest in bonds during inflationary periods, we suggest shortening the maturity to limit downside risk. This will allow you to monitor inflationary trends and continually reinvest in bonds with more favorable interest rates and returns over inflation as interest rates rise.
Treasury Inflation Protected Securities (TIPS)
TIPS are a treasury security that is indexed to inflation to protect investors from the negative effects of inflation. TIPS are considered an extremely low-risk investment since they are backed by the U.S. government. Their interest rate is fixed, and their par value rises with inflation as measured by the Consumer Price Index. While this seems like a way to protect your money during inflationary periods, there are two major problems with TIPS. First, food and energy prices are not included in the calculations for inflation! Additionally, the market anticipates inflationary pressures and adjusts the price of TIPS accordingly. This means the principal will adjust according to core inflation and not necessarily protect your purchasing power. By purchasing TIPS, you are betting that inflation will occur at or above levels built into the price. Currently, the rate of expected inflation built into TIPS is between 2.4% to 3.2%. If inflation does not rise as much or more than anticipated in the security, it is likely you could lose money relative to buying a straight Treasury bond. Depending on the maturity of the TIPS, inflation would need to grow over the 2.4-3.2% rate for you to achieve a gain on your investment.
Strategy: Anticipated inflation and demand drive TIPS prices higher, which in turn reduces the potential for protection from inflation. Also, as more investors purchase TIPS, yields tend to decrease as well. Yield-to-maturity is often shown as negative when inflation expectations are high. If unexpected high inflation occurs, consider only investing a very small percentage of your portfolio here.
Commodities/Gold
Commodities are the basic raw materials used as production inputs for the finished goods we consume everyday. Oil and gold are good examples of commodities. Let’s look at commodities in general. First, if you buy them, you must store them or pay a storage fee. When inflation is anticipated, demand for commodities rises as businesses advance the acquisition of materials necessary for production. Speculators, sensing an opportunity, buy in and drive prices even higher.
Strategy: If inflation does occur, it takes more dollars to buy commodities, leading to a perception that they are worth more, or have increased in value. Remember, there are no earnings or dividends on commodities, only price appreciation. This means that in order to make money, you have to find someone that will pay more than you did for the commodity. If you miss the initial run-up in price, your return is limited. However, your downside risk is substantial if, or when, demand falls. In the long term, equities outperform commodities. It is for this reason that we do not recommend investing in commodities.
Equity Investments
According to market data, the long-run, real annual stock return for the United States from 1900-2007 was 6.5% (approximately 10% when inflation is added). Across 17 developed markets the average real annual return was 5.8%. You might wonder how this is possible. In the long run, there is nearly 100% inflation flow through to consumers. In the short term, companies take steps to fight price increases and higher borrowing costs, but eventually prices should reflect adjustments for inflation.
There are certain industries that have the ability to pass inflation costs almost immediately to consumers. This category is referred to as non-durable goods. It includes consumer staples like food, utilities, toilet paper, and other necessities, as well as fuel. For example, when fuel prices rise, a farmer spends more on the fuel his machinery uses to plant and harvest crops. Transporting those crops to the grocer costs more, so grocery stores raise their prices to maintain their margins. Since each level of production costs more and is passed on, prices increase. As consumers, we willingly pay more for those groceries because we have to eat.
On the other hand, durable goods do not have the same pricing advantage and must initially absorb inflationary costs in their margins. For example, when the cost of automobiles or appliances rises as a result of inflation, most consumers can postpone a purchase or go without for a period of time.
Strategy: Our philosophy on equity investments is to invest in high quality, individual common stocks or mutual funds that invest in common stocks. We recommend investing in equities with a proven track record, and investing a larger percentage in the non-durable goods sector. These businesses should be able to maintain profit margins and dividends and serve as a hedge against inflation.
Final Thought
One final thought: Think about the number of companies that have existed for more than 50 or 100 years. They have weathered inflation and are still in business. Ultimately, the strong will survive. There is no reason to think that they should not be able to continue operating through another period of inflation while growing your portfolio in the meantime. If you would like to speak one of our expert about investing during inflationary times, call us at 770-429-9166 or e-mail at experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
