Inflation and the Rising Tide – Protecting Your Assets From the Storm

There is an old expression: A rising tide lifts all boats. A rising tide can also swamp them. And as signs of improvement in the economy appear on the horizon, there is a real possibility of inflation coming in with the tide. Why worry about inflation? Well, inflation is an investor’s worst nightmare. For individuals in retirement living on a fixed income, it can devastate one’s savings and lifestyle. As a bond or CD-holder, the purchasing power of regular interest income gets hit. As a stock investor, stock prices can suffer as profit margins and earnings of your equity holdings are hurt by the higher costs for inputs like energy, precious metals and labor.

Right now, Wall Street is in a good mood. For the quarter just ended, the Dow has gained about 14%, the S&P increased 14.5% and the NASDAQ was up 15%. In fact the last time the Dow saw such a large quarterly surge was back in the fourth quarter of 1998 when it rose more than 17% as the dot-com bubble was forming. This quarter’s rally continued a trajectory that began in mid-March 2009. It has been primarily propelled by glimmers of light at the end of the tunnel. A variety of positive statements from Federal Reserve Chairman Ben Bernanke contributed to a more optimistic view. Residential real estate sales continued to come back mostly prompted by a first-time homebuyer tax credit. Corporate earnings have been up.

The popular “cash for clunkers” program spurred auto sales and by some measures consumer spending increased marginally even without the impact from auto sales. Despite the Wall Street rally, Main Street is still hurting: unemployment continues to rise, business and personal bankruptcies have increased, bank failures are at their highest level and the dollar continues to weaken fueling fears of inflation down the road. Signs of future higher inflation are on the radar screen: All the government economic stimulus here and abroad coupled with mounting public debt; the Fed’s projected end of a program in March 2010 that will likely lead to higher mortgage rates; a Fed interest rate policy which has no place to go but up and rumblings that foreign governments and investors may not want to continue at their current pace of supporting our debt habit. So how do you position yourself to profit whichever way the tide turns?

Now, more than ever, it is important to have a risk-controlled approach to investing.

This is centered on an age-based allocation that includes exposure to multiple assets. This is why we will continue to manage portfolios with an allocation to bonds and fixed income but there are ways to protect from the impact of inflation and still allow for growth.

1.) Include dividend-paying equities: Using either mutual funds or ETFs that have a focus on dividend-paying stocks will help boost income as well as return. Stocks that pay dividends have averaged near a 10% annual return compared to a total return less than half of that for stocks that rely solely on capital appreciation. Better yet, consider stock mutual funds or ETFs that focus on stocks that have a record of rising dividends

2.) Stay short: By owning bonds, ETFs or bond mutual funds that have a shorter average maturity, you reduce the risk of being locked into less valuable bonds when higher inflation pushes future interest rates up.

3.) Hedge your bets with inflation-linked bonds: Fixed-rate bonds offer no protection against inflation. A bond that has changes linked to an inflation index (like the Consumer Price Index) like TIPS issued by the US-government or ETFs that own TIPS (like iShares TIPS Bond ETF – symbol TIP) offer an opportunity for a bond investor to get periodically compensated for higher inflation.

4.) Float your boat with Floating-Rate Notes: These medium-term notes are issued by corporations and reset their interest rates every three or six months. So if inflation heats up, the interest rate offered will likely increase. Yields in general are higher than those offered by government bonds typically because of the higher credit risk of the issuer.

5.) Add Junk to the Trunk: Hi-yield bonds are issued by companies that have suffered down-grades – sort of like homeowners with dinged credit getting a mortgage. Yields are set higher than most other bonds because of the higher risk. Yet, as inflation heats up with a growing economy, the prospects of firms that issue junk improve and the perceived risk of default may drop. So as the yield difference narrows between these “junk” bonds and Treasuries, these bonds offer a “pop” to investors.

6.) Own Gold and Other Commodities: Whether as a store of value or hedge against inflation, precious metals have a long history with investors seeking protection from inflation. It’s usually best to focus on owning the physical gold or an ETF that is tied directly to the physical gold. Tax treatment of precious metals is higher because of its status as a “collectible” but this is a minor price to pay for some inflation protection. And because the demand for commodities in general increases with an expanding economy or a weakening dollar (in the specific case with oil), owning funds which hold these commodities will help hedge against the inflationary impact of an expanding economy.