"The cult ofinflation may only have just begun."
That was a bold and eye-opening sentiment legendarybond fund
manager Bill Gross expressed in the summer of 2012.
What on Earth is he talking about? After all, inflation has been
declining for more than three decades and is nowhere to be found in
today'seconomy .
But Gross has a point.
Inflation was virtually non-existent in the 1930s and the 1960s,
but came roaring back in each of the subsequent decades.Will past
be prologue?
There's a decent chance we'll eventually be prepping for a fresh
bout of inflation for one simple reason: The Federal Reserve will
eventually need to reverse course, unwinding its massive
quantitative easing programs that have taken manybonds off
themarket . Asthe Fed pushes all of those bonds back into the
market, many fear it will trigger an unwanted (though not
unexpected) rise inbond yields and inflation.
Inflation is a pernicious beast. It eats away at the value of
many assets likestocks , leaving many poorer in the process. In the
1970s, the S&P 500 rose less than 20% in value. Yet during that
decade, inflation soared, meaning the inflation-adjusted value of
the S&P 500 actually dropped by more than 25% (before dividends
are accounted for). Indeed, traditional stocks always tend to fare
poorly at times of high inflation (though it's worth noting that a
modest move up in inflation from current levels would not
necessarily be so deleterious to stocks).
Gold bugs rule
Fearing inflation's return, investors have flocked to gold, sending
its price up from less than $500 in the middle of the last decade
to a recent $1,675.
It's fair to wonder whether that stunning upward move already
reflects any inflationary times to come. So rather than simply sit
on a cache of the shiny yellow metal, you should takenote of four
otherinvestments that are likely to hold their value if we return
to inflationary times.
Here they are...
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1. Commodities and real assets
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Gold is just one of many commodities that tend to rise in
price as the corrosive effects of inflation start to bite.
Other precious metals such as silver and platinum have
traditionally served as inflation hedges as well, as have
other commodities such as copper, steel and grains. The cost
to process these goods rises in inflationary environments,
which producers must pass on to buyers. Even in a weak
economic environment, these items can still rise in value as
producers cut output to the point where historical
processing profit levels are restored.
But the greatest hard-asset inflation hedge may
simply be in housing. This is because home prices tend to
reflect the cost of construction, with a built-in profit
mark-up for builders. Inflation causes all of the materials
and labor associated with construction to rise in price.
Anyone who bought a home in the 1960s saw
their investment surge in value by the 1980s
thanks to high inflation -- even as their
monthly mortgage payments stayed flat.
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2.
Foreign stocks |
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Rising inflation tends to erode the value of a currency
, as foreign-exchange traders shift funds to other
markets where inflation trends remain in check.
The absolute rate of inflation doesn't matter to
them; simply the direction. So even though Brazil's inflation
is the 5% to 6% range, which is well above our own 2%
inflation rate, currency exchange rates already reflect that.
So if our inflation rises toward the rate of Brazil's, then
the Brazilian real is likely to strengthen against the U.S.
dollar. As a result, an investment in Brazilian stocks would
be boosted by the strengthening local currency.
In recent years, the Australian dollar, the Swiss franc
and the Brazilian real have all strengthened against the
dollar, boosting the returns of U.S. investors in those
markets. Which countries' currencies will appreciate against
the dollar in the years ahead? It's hard to know, which is
why a broad-based and balanced approach to foreign stocks is
the wisest path.
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3.
High-yield bonds |
Anyoneinvesting back in the 1970s will tell you that
bonds were the name of the game. Inflation began to move up
(and eventually surpass) double-digit rates, but so did bond
yields. Of course, any investor who owned bonds before the
inflationary crisis of the 1970s missed out, and bond funds
fell in value in the 1970s as bond yields soared. That's why
it's a bit premature to seek out the inflation hedge of bonds
now. Instead, keep an eye on inflation and rates in the years
ahead. At some point in the years ahead, investors will
likely be treated to robust yields in some of the
safest fixed-income arenas again.
Investors can hedge against any inflation to come by
buying high-yield bonds. These bonds, typically issued by
companies that are just a notch below "blue-chip" status,
already offer impressive yields.
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4.
Stocks with rising dividends |
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Of course, many companies operate in inflation-resistant
industries. If prices rise, then companies like
Coca-Cola (
KO
)
,
Anheuser-Busch InBev (
BUD
)
and
Procter & Gamble (
PG
)
simply raise the prices of their own products. This enables
these kinds of companies to boost their dividends at a
consistent rate.
Let's look at how Coca-Cola performed in the 1970s. In
1970, the company paid out a dividend of $1.44 a
share. By the end of the decade, that payout had risen to
$3.92 a share (adjusting for a 2-for-1 stock split
in 1977). That works out to be a 12% compound
annual growth rate, which is even higher than that
decade's inflation rate of 8%.
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Risks to Consider:
These variousasset classes are also affected by other factors
that influence prices. For example,real estate values have already
begun to rebound prior to the appearance of higher inflation, but
they could take a short-term hit if rising inflation took a toll on
the U.S. economy. In this instance, it's important to see an asset
such as real estate as a long-term inflation hedge, though it may
not act as one in any short-term time frame.
Action to Take -->
Thestock market has risen sharply since the early 1980s, in part
because inflation has been steadily falling, making
inflation-sensitive assets like bonds relatively less appealing.
Yet this era may be coming to an end, so investors need to brush up
on their options now.
As noted earlier, a moderate rise in inflation to the 3% to 4%
range would not necessarily be bad news for U.S. stocks. Indeed,
the move up on rates may be a signal of rising economic activity,
which is a clear positive for stocks. But a move in inflation into
the mid to upper single-digits would likely be a strong headwind
for stocks. Simplyput , stocks fail to hold their own, on an
inflation-adjustedbasis , when inflation is at abnormally high
levels. That was surely the lesson learned in the 1970s.