New Ways To Allay Inflation Worries

July 28, 2011

In a world where inflation is on everyone's mind, fresh thoughts on how to deal with it are welcome.

 

Inflation erodes the purchasing power of money and can negatively influence portfolio returns. Lately, the loose monetary policy1 embraced by the Federal Reserve in the wake of the financial crisis of 2008 has created anxiety about the purchasing power of the U.S. dollar. Anticipating an extended period of inflation or a falling U.S. dollar (or both), many investors have flocked to alternative investments in an attempt to combat the effects of a declining fiat2 currency. As a result, investments in Treasury inflation-protected securities (TIPS),3 precious metals such as gold, and commodities have exploded in recent years.

The potential for inflation can be unsettling, but understanding some of the shortfalls of the aforementioned “inflation protectors” may help create a better investing experience if inflation does indeed arise.

Traditional Inflation-Adjusted Assets: Drawbacks

  • U.S. Treasury Inflation Protected Securities (TIPS): Investors have recently paid a premium for inflation protection with TIPS, which results in low or negative current yields.4
  • Gold: Does not generate income and is difficult to value.
  • Futures-based Commodities5: Return streams have shifted in recent years.

TIPS
In theory, TIPS could be an ideal investment for investors looking to weather an inflation storm; the principal value of the bond increases with inflation as measured by the Consumer Price Index. In reality, fears about inflation could drive the cost of protection so high as to turn the risk/reward trade-off into a losing proposition. Recently, the fear of inflation has created a premium price for five-year U.S. TIPS bonds, which has resulted in negative current real yields since the end of 2010. Since TIPS were first introduced in 1997, the yield on the five-year TIPS bonds has averaged above 2 percent and the current yields are negative. A negative current yield means investors are paying for the option to get the inflation adjustment in the future. Low or negative yields correspond to high bond prices, suggesting that if TIPS real yields were to return closer to their historic averages, the TIPS bond prices could suffer.

5- and 10-Year U.S. TIPS Real Yields: July 31, 1997 – April 29, 2011

Source: Bloomberg
Past performance is not indicative of future results.

Gold
As gold has traditionally been considered a store of value, every announcement pertaining to Fed action implemented to help stimulate the economy appears to drive the price of gold to new highs. Investors in the shiny metal often argue that global governments intend to print money and devalue fiat currencies due to debt and deficit conundrums.

The drawback of owning gold is that it is difficult to value. Is it over- or undervalued at $1,500? How do investors even begin to answer that question? Warren Buffett provided thoughts in a CNBC interview in February 2011:

  “If you took all the gold in the world, it would roughly make a cube 67 feet on a side … it would be worth at today’s [February 2011] market prices about $7 trillion … For $7 trillion … you could have all the farmland in the United States, you could have about seven Exxon Mobils, and you could have a trillion dollars of walking-around money… And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me—touching it and fondling it occasionally—call me crazy, but I’ll take the farmland and the Exxon Mobils.”  

 

 

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