Inflation Probably Won't Be Bad, But Will Probably Come; What Should You Be Doing?


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Inflation! To those of us over a certain age who remember the days of double digit annual price increases, even the word is scary. Ever since the US Federal Reserve embarked upon a policy of Quantitative Easing (QE) that word has been bandied about but, to many people’s surprise, there is still no real sign of it in economic data.

We are all, to some extent, monetarists now, and believe as a simple truth that a massive increase in the money supply must, one day, lead to some kind of inflation. I have been around markets too long to state anything as certain, but eventually it is reasonable to assume that all of that newly created money will one day chase goods and push prices up somewhat. A move towards 4 or 5% headline inflation in the US and therefore higher commodity prices looks like a reasonable bet, at least in theory.

In reality, however, betting on that supposition has been an expensive proposition over the last few years. Normal hedges against coming inflation, such as commodities, have had a disappointing couple of years, especially in comparison to stellar returns in the stock market. That is why I believe that they should now be a part of everybody’s portfolio, they are relatively cheap.

It’s not that I think we are on the verge of some scary inflationary or hyper-inflationary scenario. In fact, I have a hard time keeping a straight face when I talk to those that espouse that theory; they were saying the same thing in 2011 and have lost a lot of money as they await financial Armageddon. It’s just that, in the grand scheme of things, a sensible hedge via a commodity ETF is reasonably priced at the moment.

Not all commodity tracking ETFs are created equal, however. There are, of course, specialist funds for individual commodities, the SPDR Gold Trust (GLD) and the oil funds such as OIL and USO are the most popular, but these two sectors have their own dynamics.

Gold has been going through a serious deleveraging process following the spike to above $1800 in 2011, as the 5 year chart for GLD demonstrates.

Recent rises suggest that that period of consolidation may be over, and I am generally bullish on GLD, but it is near the top of an established trading range that approximates to 115-140 (marked by the bold yellow lines), so it makes more sense in this case to wait for either a breakout or a return to the lower end of the range.

Oil is another story. Recent drops in the price could tempt me a little, but as I outlined here, there are long term pressures on the price of oil that will limit any upside. Shale oil recovery and deepwater drilling technology will continue to improve, resulting in a steady supply increase just as previous investments in “alternatives” begin to pay off in terms of more affordable energy sources and slow down the rate of demand increase for fossil fuels.

The problem for investors is that many of the best known ETFs that track commodity indices are heavily weighted towards both oil and gold. In the PowerShares DB Commodity Index ETF (DBC), for example, oil and gold futures contracts account for over 60% of the fund’s value.

Obviously, in an inflationary environment, both commodities will increase in price, but the internal dynamics of these markets may be enough to restrict that rise in a scenario of moderate overall price increases. It may, therefore, pay to look for a fund with a more even distribution of investments.

The US Commodity Index Fund (USCI) provides a better solution to those looking for commodity exposure less weighted to gold and oil. The fund tracks the SummerHaven Dynamic Commodity Index Total Return, and as such is rebalanced each month to include a rules based selection of 14 commodity futures from a list of 27.

Each commodity is held in equal weight, so while oil and gold could both be included, they won’t make up an inordinate percentage of the assets held. ETF purists won’t like the fact that this activity results in a relatively high expense ratio of 0.95%, but that is less of a concern to me than the nature of the fund.

USCI has been around for just over three years and has, over that time, reflected the somewhat depressed state of the commodities market, but has shown signs of life since the middle of January.

Even despite that 8% increase over the last couple of months, this looks like a reasonable level to invest as a simple hedge against price rises in the US in the coming years. My head may tell me that Bernanke, and now Yellen, know what they are doing and can extricate the country from a period of monetary stimulus in an orderly fashion, but my heart and history tell me that that is by no means certain. I know one thing; having experienced high inflation, I’ll sleep a little easier knowing that I have some protection in place.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , ETFs , Commodities , Investing Ideas
Referenced Stocks: GLD , OIL , USO , DBC , USCI

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Martin Tillier

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