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July 26, 2011 at 08:00 PM
During the 2008 credit crisis, asset prices fell and the prospect of a general deflation was the biggest worry. Today, deflationary fears are still present but so is the threat of out-of-control inflation. Will inflation become public enemy number one? How bad will it get? Let’s evaluate these questions.
Measuring Inflation
The Consumer Price Index for All Urban Consumers (CPI-U) is a closely followed indicator that benchmarks the average change in retail prices for a basket of over 200 categories of assorted goods and services. Changes in the CPI affect Social Security payments of more than 50 million Americans along with recipients of food stamps. While it isn’t the only inflation yardstick, the CPI is arguably the broadest and most influential measure of nationwide inflation.
“There were numerous changes made to how CPI is determined in the 1980s and 1990s,” states Daryl Montgomery, author of Inflation Investing: A Guide for the 2010s. “All of these changes lowered the reported inflation rate. If the CPI number is calculated the same way over time, a very different recent history of inflation emerges. Inflation was actually around 13 percent at the commodity peak in 2008.”
The May CPI figures showed a gain of 3.6 percent over the past 12 months, before seasonal adjustments. Other subcategories like the energy index increased 21.5 percent and the food index has risen 3.5 percent. All of these figures have been rising in recent months.
Broadly diversified commodities are confirming the trend of higher prices too.
The GreenHaven Continuous Commodity Index Fund (GCC) is ahead by 34.75 percent over the past year. GCC follows an equal-weighted index of 17 commodities that are averaged across the futures curve six months out. The fund has significant exposure to grains, livestock, energy and soft commodities. In addition, GCC is rebalanced each day in order to maintain each commodity’s weight as close to 1/17th of the total as possible.
Even with a recent pullback in gasoline and food prices, commodities are higher compared to early 2010.
“Many people tell me they are buying cereal and Triscuits, paying the same price per unit — but noticing the box sizes have shrunk. And the free prize in the cereal box? Certainly, that is just a childhood memory,” notes Joseph G. Witthohn, CFA with the Investment Strategy Group at Janney Montgomery Scott.
It’s the Dollar
With the dollar slumping, more people are finally making the connection to this particular trend and more expensive goods. Since nearly all major commodities are priced in U.S. dollars, declines in the dollar will automatically make commodities more expensive. And the increasing number of new dollars printed continues to dog the dollar’s recovery.
“Inflation in the 2000s will be much worse than in the 1970s because the current amount of money printing is way beyond anything that happened back then,” argues Montgomery. He projects there will be up to a 10-year lag from when the maximum amount of monetary stimulus takes place and the peak inflation rate. He thinks a 100 percent price rise in three years or less is a real possibility.
While it’s difficult to foresee whether inflation will surge that much, it’s a far cry from what the Federal Reserve expects. The Fed projects inflation of less than 2 percent for each of the next three years. At the same time, Fed Chairman Ben Bernanke acknowledged the danger of inflationary pressures. In his testimony to Congress earlier in the year he admitted, “Sustained rises in the prices of oil or other commodities would represent a threat both to economic growth and to overall price stability.”
Portfolio Strategies
What’s the best way to build an investment portfolio for the threat of higher inflation? “Ultimately, hedging inflation’s risk over time requires using a mix of assets, since any one asset class has its own set of pros and cons as a defense against inflation,” says Jim Picerno, editor of CapitalSpectator.com and author of Dynamic Asset Allocation.
Let’s analyze a few ETF strategies that hedge against inflation.
Dividend Paying Stocks
If equity returns aren’t going to be as high as before, that means dividends will play a larger role in the total return that investors receive. In this regard, investing in stocks with rising dividends is the way to capitalize. “A good way to invest this way is by purchasing ETFs that only own stocks with a long history of rising dividends, says Witthohn.
