Do you need inflation protection?
Investors have an unprecedented array of inflation-protection tools to safeguard their portfolios: from gold and inflation-protected bonds to commodity mutual funds. Choosing how to hedge against inflation depends on your situation and outlook.
The Federal Reserve's unprecedented easing has pushed it between a rock and a hard place. The longer it stokes the economy's engines with unprecedented bursts of money, the more analysts worry about inflation. Whenever the Fed talks of pulling back, the markets tank – as it did last week. Mortgage rates, meanwhile, saw their biggest one-week jump in 26 years.
What's a central banker to do?
Two things could force the Fed's hand: a loss of confidence in US debt in the bond market or the reappearance of inflation. Many analysts are convinced that, given the scale of the Fed's pump priming, inflation is inevitable.And it doesn't take a doomsday scenario. Even moderate inflation takes its toll. A $1 million portfolio in 1990 would take more than $1.75 million to replicate today.
For investors worried that inflation will take off soon, there is an unprecedented array of inflation-protection tools to safeguard a portfolio: from gold and inflation-protected bonds to commodity mutual funds. Choosing how to hedge against inflation depends on one's individual situation and outlook.
"A variety of issues are causing concern among investors trying to preserve their real wealth, including rising commodity prices, rapid economic growth and resource use in emerging markets, ultra-loose monetary policy in developed markets, and social and political unrest in resource-rich countries around the world," says a Morningstar research report issued in January. "The prospect of higher inflation affects investors because the higher the inflation rate, the faster the value of their savings erodes."
Gold, the traditional inflation hedge, has lost some of its luster lately. Since peaking in 2011, the precious metal has declined by about a third. Many analysts think gold has further to fall. Still, should the stock market fall sharply or inflation begin to rear its head, gold could shine again. There are several strategies for owning gold directly, either holding the metal oneself or through an exchange-traded fund, or indirectly, by owning shares of gold mining companies or shares of a mutual fund or ETF that invests in them.
For those especially worried that shares of a mutual fund or gold mining company could become worthless, holding physical gold, either in coins or bars, is a big attraction, said Edmund Moy, former director of the US Mint and now chief strategist for Morgan Gold, in a telephone interview.
"Physical gold is always going to be worth something," he said, "so physical gold has that extra measure of protection for people concerned about inflation." (Morgan is a gold-investing firm in Irvine, Calif.)
Another popular option for inflation-phobes are US Treasury Inflation Protected Securities or TIPS. They have the advantage of automatically adjusting coupon payments and final principal payments to track the federal consumer price index. The disadvantage is that as Treasury bonds, they offer the lower returns of conservative bonds at a time when interest rates are at record lows. Since TIPS themselves tend to be 20- or 30-year bonds, investors buying TIPS today would have below-market returns whenever interest rates rise to more normal levels, Chris Philips, senior analyst in the Vanguard mutual fund company's investment strategy group, told Morningstar. Accordingly, Vanguard offers its own Vanguard Inflation-Protected Securities Fund (VIPSX), which focuses on holding "the shorter end of the vast maturity spectrum" of TIPS "to track inflation more tightly."
Another inflation hedge is commodities. Some analysts foresee a boom, based on forecasts that finite natural resources won't be able to keep up with a growing, wealthier world population. Commodity fund investments in raw materials such as agriculture, energy, and precious metals offer many choices, whether investing directly in actual commodities or in commodity-linked derivative instruments. Investors can choose commodity funds such as Nuveen Long/Short Commodity Total Return Fund (CTF), DWS Enhanced Commodity Strategy Fund (SKNRX), PIMCO Commodity Real Return Strategy Fund (PCRDX), Fidelity's Global Commodity Stock Fund (FFGCX), or its Select Natural Resources Portfolio (FNARX) to diversify their holdings.
But now may not be the best time to jump in, since recent reports from the World Bank and Citigroup predict slower growth in demand for commodities and therefore potentially stagnant or lower commodity prices. "Since their highs in 2011, commodities like gold, silver, and oil have all been in relentless downtrends," the Bespoke Investment Group points out. After price jumps in April for three popular ETFs – SPDR Gold Shares (GLD), United States Oil Fund (USO), and iShares Silver Trust (SLV) – "the rallies have all since fizzled and resulted in lower highs," adds Bespoke, a market-strategy firm in Harrison, N.Y.
Before you rush out to buy gold, TIPS, commodities, or some other inflation hedge, consult your financial planner. You may find you already are well protected against inflation, because the best inflation hedge could be something you already have:
•A stock portfolio, which historically has offered returns above the rate of inflation.
•A salary and benefits that go up along with inflation.
•A monthly Social Security check adjusted for inflation and, possibly, a pension that does the same.
Financial planners generally figure that getting a $2,500 Social Security check every month is the equivalent of having $400,000 in conservative inflation-protected investments – thereby reducing the percentage of your assets that you otherwise might use to hedge against inflation.