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Viewing entries tagged with 'inflation'
Managing Inflation Risk
Managing Inflation Risk
As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt. Many people are asking how they can prepare for potentially higher inflation. This blog post explores two basic ways to address inflation uncertainty and highlights asset groups that may prove useful.As you consider strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market’s expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage.
Hedging vs. Total Return Strategies
Investors can prepare for unexpected inflation by following one of two basic strategies—hedging the immediate effects of inflation or earning a total return outpacing inflation over time.
Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)
Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection.
In a total return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. This investor is willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks.
To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS). Let’s consider each of these:
Stocks
Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year. (see end notes) To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return.
Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.
Fixed Income (Bonds)
Higher inflation can hurt bondholders in two ways—through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.
Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth.
Treasury Inflation-Protected Securities (TIPS)
Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation.
TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.
However, keep in mind TIPS prices have also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase.
Commodities
Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging.
Investors should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broad-based stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.
Summary
While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio.
As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:
• Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.
• Hedging unexpected inflation has a cost. Investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks—and some have much higher volatility.
• Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility.
Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.
Complimentary related commentary include this Money Cents Newsletter article:
Managing Asset Allocation in Your Investment Portfolio
Endnotes
Real return calculation: (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago.
Disclosures
Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics.
Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes.
CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included.
The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money.
Diversification neither assures a profit nor guarantees against loss in a declining market.
2009: The Financial Year in Review
2009: The Financial Year in Review
“Many an optimist has become rich by buying out a pessimist.”
Robert Allen
The year in brief. The market improved; the economy improved. The doomsayers with visions of “Dow 4,000” were disproven. The Great Recession in all probability ended. Unemployment reached and remains at 10%, and major automakers went bankrupt, reorganized and shed brands. Stocks went on a nine-month rally of historical proportions. Major healthcare reform made its way through Congress. It was a hard year for Main Street but a gratifying year for Wall Street.
Thinking Ahead about Inflation?
THINKING AHEAD ABOUT INFLATION?
HERE ARE A FEW WAYS TO PROTECT YOURSELF
While the struggling economy has put a vice on inflation, many experts don’t expect things to stay that way for much longer. Why? Many economic experts fear the current level of federal spending will inevitably lead to printing more money, and that’s regarded as an inflationary solution. The solution is to "reflate" occurred in the last seventies-early eighties during the Carter administration (recall the economic mailaise speech?). Printing money resulted in money market fund yields above 10%, mortgages above 10%, and business loans with similar double digit rates. Now is the The time to plan for inflation.
When Will Interest Rates Rise?
What factors might influence the Fed in the near future?
How long can the federal funds rate stay so low? The Federal Reserve has publicly stated that it will keep the federal funds rate between 0% and 0.25% for an “extended period”. Many economists don’t see the Fed raising rates until well into 2010. Yet rates will move north someday. How soon might that happen? And how could the Fed delicately move rates north without hampering the recovery? In a post on Morningstar Advisor Market Blog, I opined concerning how the Great Recession might conclude. Inflation, deflation, and interest rates all interact in this scenario. This post addresses the issues surrounding the root causes of inflation, the delimma facing the Federal Reserve on interest rates going forward, while providing historical context. This is a good preliminary read as you evaluate your business decisions and investment allocation for 2010 and the years beyond.
The Barron’s argument. On October 19, Barron’s published a piece titled “C’mon, Ben!” in which senior editor Andrew Bary called for short-term interest rates of 2.0%. Why? “Super-low short rates are fueling financial speculation, angering our economic partners and foreign creditors, and potentially stoking inflation.” One concern is that by keeping rates so low for so long, the Fed might risk an asset bubble – recall how the housing bubble was aided by low interest rates. The article called for the Fed to exit the crisis mode policy of the last 12-18 months.(source)
What would raising short-term interest rates to 2% possibly accomplish? Well, the tactic could prove a decisive and wise move to control inflation (CPI is on track to come in at 2% for 2009, so Bary argues that inflation is indeed back) and aid the dollar.(source) The downside, of course, is that the move would amount to a right cross to the jaw for the stock market (and possibly the commodities markets).
The challenge for the Fed. The stock market is having a great year; the economy is not, with unemployment north of 10% and the business and real estate sectors taking a long time to recover. Given this, most economists and market analysts see no incentive for the Fed to make a move. (In fact, St. Louis Fed President James Bullard has cited “jobs growth and unemployment coming down” as a “prerequisite” for increasing interest rates.) (source) The challenge for the Fed is how to signal or hint at a move in the coming quarters in a way that seems reasonable or non-disruptive to the recovery.
There are possible hints of inflation here and abroad (renewed strength in emerging market economies, gold prices soaring and the dollar hurting). On October 22, Philadelphia Fed President Charles Plosser told Bloomberg Radio that he felt the time to raise rates would come sooner than most Fed officials believed. The next day, a Bloomberg data survey showed that traders had increased the probability of a federal funds rate hike in 1Q 2010 to 48% from 37% the day before.(source)
The prevailing notion. TheStreet.com published a rebuttal of sorts to the Barron’s article – a piece titled “It’s Absolutely Not Time to Raise Rates, Ben!” in which author Ron Insana argued that the recovery was too fragile to prompt any notion of raising the federal funds rate. Many analysts feel that a rate increase is simply unwarranted without a demonstrably healthier job market, housing market and banking system.
Out west, San Francisco Fed President Janet Yellen told reporters that she didn’t anticipate a rate increase or any tightening of the Fed’s rescue programs in the next several months.(source) So the question remains “when” – and the Fed must move as carefully as ever.
No SSI Increase for 2010
NO SSI INCREASE FOR 2010
The Social Security Administration (and the IRS) leave
benefits and retirement plan contribution limits unchanged.
SSI will remain flat for the first year since 1975. Social Security benefits are keyed to inflation. So what happens when year-over-year inflation becomes negative? No cost-of-living adjustment (COLA) occurs to increase your Social Security income. On October 15, the Social Security Administration announced that there would be no COLA for 2010. (The 2009 SSI COLA was 5.8%, the largest boost since 1992.) (source)
“What do you mean, negative inflation?” That’s the question some SSI recipients are asking. Aren’t prices seemingly going up at the grocery store every day – and going up everywhere else?
Unfortunately, the federal government doesn’t measure consumer inflation with a price check on aisle six. It uses the Consumer Price Index (CPI), which is really an estimation of the average prices of consumer products we buy. There is also core CPI, which excludes food and energy costs.
