Asked & Answered: Inflation

Marjorie from Allentown, PA writes:

I think we are facing a period of much higher inflation.  Should I move my investments in to gold to protect myself?

Friedenthal Financial:

Marjorie,

Firstly, kudos for thinking about inflation when assessing your investment needs.  All too often people only think about the number of dollars they’ll have in retirement…not how much those dollars will buy.  For those who keep much of their funds in cash (t-bills, money markets) because they fear losing money in the market, the long run may prove very costly because of higher inflation.

While gold does tend to appreciate with inflation over a long period of time, stocks are generally more correlated.  Please note that correlation is certainly not the only investment criterion and can fluctuate over time.  Many stocks, unlike gold, also provide dividend income.  However, stocks are typically more volatile than gold.  A good investment strategy generally incorporates a variety of asset classes and sectors which provide a risk profile suitable to the investor’s needs and risk tolerance.

As another alternative, consider an allocation to Treasury Inflation Protection Securities (TIPS).  These are US Treasury securities which have principal that increases with inflation (CPI).  In exchange for this appreciating principal, the investor accepts a lower coupon than an equivalent maturity Treasury security.  TIPS provide direct benefit in periods of higher inflation and are generally much less volatile than stocks.  We often use an ETF (exchange traded fund) with the ticker “TIP”, which is a basket of TIPS, as a way to invest in this sector.

Increased inflation can be caused by a number of different factors including, but not limited to, economic expansion, increased money supply and low unemployment rates.  We believe that inflation in the US economy, 2.3% y/y in March, is being supported by commodity prices while being constrained by narrow wage growth due to continued high unemployment levels.  As a result of the actions by the Federal Reserve to stabilize the economy, the US money supply has increased, while the velocity of money through the economy remains sluggish.  As the unemployment rate declines and consumer spending increases, we believe that the constraint on inflation will abate and inflation will start to materialize.

Data Source: Bloomberg

Market expectations for inflation can be estimated by comparing the yield of TIPS with the yield of equivalent maturity Treasury securities.  Currently, 10-year TIPS imply an average inflation rate of approximately 2.4%/yr (as of 4/29/2010) over the next ten years.  Investors who believe that the rate of inflation will be higher in that period might buy TIPS instead of standard treasury securities.  The inflation rate (measured by headline CPI) over the past 50 years is just shy of 3.8%/yr.  

Different sectors of the equity market have varied relationships with inflation.  Overweighting a sector with a strong correlation to CPI may be a good way to hedge the effects of inflation.  US Sectors that have historically exhibited high correlations with CPI include Energy, Consumer Staples, and Basic Materials.  Some commodity rich foreign countries (Chile, South Africa, Russia, Australia, etc.) may also exhibit a higher correlation with CPI when their equities are US dollar denominated.  On the other hand, Telecom, Information Technology and Utilities have relatively low correlation to CPI. If you believe higher inflation will be an issue in the future you might choose a commensurate sector based allocation strategy.

Data Source: Bloomberg

The contrary opinion is that the US consumer will not recover very quickly.  In this scenario, unemployment remains elevated for a more prolonged period and consumer spending is muted.  Inflation could decline or even become deflation.  If, however, commodity prices rise while unemployment remains elevated, we enter a period often called “stagflation” (stagnant growth with inflation).  In the mid 1970′s and early 1980’s, when stagflation was significant, stocks generally languished.

We hope that helps and provides fodder for discussion.  Please let us know if we can be of further service!

The Friedenthal Financial Team

856-210-6494 (Office)

856-210-1565 (Facsimile)

info@friedenthalfinancial.com

www.friedenthalfinancial.com

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This blog is only intended to provide answers to questions of general interest we receive on the topics of investments, finance, capital markets, and economics and to serve as a historical repository for our e-mailed Asked & Answered column.  We are not rendering or offering to render personalized investment advice or financial planning advice through this blog or any of its attached links.  Friedenthal Financial will render investment advice to potential clients only after:  (i) we have delivered a disclosure statement to the potential client as required under applicable securities laws, and (ii) the potential client has executed and delivered Friedenthal Financial’s investment advisory contract to us.  We will provide investment advisory services to clients only in states in which Friedenthal Financial is registered as an investment adviser or is exempt from registration.

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