Inflation isn't high on the list of most people's fears right now. With the global economy expected to contract nearly 3% this year and the U.S. still just limping toward recovery, the most immediate concern is falling, not rising, prices.
The "smart money," however, is betting on inflation. And that means now may be the right time for average investors to take a few small steps to secure the purchasing power of their cash.
The Federal Reserve has held down interest rates while pouring out $1.5 trillion in an effort to reinflate the economy. In the long term, those actions could cause prices to rise significantly, says Brian Weinstein, a managing director who oversees inflation-protected assets at investment company BlackRock.
TIPS for guarding against inflation
So what can investors do to inflation-proof their portfolios?One option is to invest in TIPS, or Treasury inflation-protected securities. Unlike regular Treasurys, whose value can be eroded by inflation, TIPS are adjusted to reflect changes in the Consumer Price Index. TIPS pay a fixed interest rate on a CPI-adjusted principal. So if you buy a security with a 2% return for, say, $100 and inflation rises to 3%, the government will pay you 2% on $103, for a principal of about $105. With regular Treasurys, if you buy $100 worth with a 3% return and inflation rises to 3%, your principal would be $103. And the $3 earned from interest wouldn't buy you any more than the $100 did previously.
So why buy Treasurys? Because they often have return rates that are significantly higher than TIPS. When inflation isn't a problem, Treasurys yield better returns than TIPS.
TIPS can be purchased directly from the U.S. Treasury Department or by buying into a fund that owns them. The advantage of a fund is that investors can sell their positions at any time. The Blackrock Inflation Protected Bond Fund (BPRAX, news, msgs), which is 100% in TIPS, has increased nearly 30% in value so far this year.
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Buy commodity hedges
If you've ever wanted to buy pork bellies or grain futures, or just to stock up on silver or gold, now may be your time. Commodities are not for the risk-averse or folks looking to retire in the next five years, as they can be volatile and are not as easily traded as stocks. But for investors who can withstand some ups and downs, industrial and precious metals, grain, oil and other commodities can be effective hedges against inflation.The reason is that commodities have intrinsic value. Grain, for example, is something people are willing to spend money on even in the toughest of times. If the value of the dollar decreases, the price of grain will increase because the demand for grain (and the meat of animals fed with grain) will remain roughly the same.
An investor who believes inflation is on the horizon could protect himself by purchasing commodity futures, which are basically contracts that allow the purchase of goods for a set price at a later date. If an investor has a futures contract allowing him to buy grain at $10 a bushel and inflation pushes the price up to $13 a bushel, the difference is profit.
The problem with commodity futures, or any contract tied to a specific commodity, is that prices can vary based on an array of potential factors. Crop-destroying storms can decrease supplies, causing prices to rise, and hardier strains and pesticides can increase yields, thus decreasing the price of grains. Consumption habits could also change. A scare over "mad cow" disease, for example, could drastically reduce demand for grain fed animal products, thus reducing the price of wheat.
Given the risk to individual commodities, it may make more sense for some investors to buy into a basket of such goods. Doing so spreads out the risk that an individual commodity could be negatively affected by a supply or demand shock. Investors can do this by purchasing exchange-traded funds, or ETFs, through their broker or directly via online stock trading services such as Scottrade and E-Trade.
There are also funds that lump together the three main commodity plays: agriculture stocks, energy stocks and metals stocks. ETFs that track the performance of the Dow Jones AIG All Commodities Index (ESGJF, news, msgs), which includes 19 commodities, or the even larger Goldman Sachs (GS, news, msgs) commodity index are among the ways investors can buy large baskets of commodities. Investors can also look for funds that invest directly in commodity futures or the goods themselves. One such fund, Elements Rogers International Commodities Fund (RJI, news, msgs), is up more than 14% for the year.
John Brynjolfsson, the chief investment officer of hedge fund Armored Wolf, recommends metal commodity funds as an inflation hedge. Unlike grains and oil, metals can be easily stored, so their prices can respond more quickly to anticipated inflation. Grains, on the other hand, can go bad before prices start to increase.
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Inflation: The new front in the financial fightCatherine Holahan explains the reason for inflation concerns and how it could delay an economic recovery, as well as drag down the market.
Bet against the dollar
Another inflation play for consumers is currencies. Consumers who are paid in dollars and want to ensure they can still afford to buy products from, for example, Europe, even if the value of the dollar decreases relative to the euro, can purchase euros directly. If inflation weakens the dollar, those euros have greater purchasing power.As with commodities, investors can buy a basket of currencies or an ETF that tracks the dollar exchange rate to several currencies in order to guard against any one currency inflating relative to the dollar. PowerShares DB US Dollar Index Bearish Fund (UDN, news, msgs) is one such vehicle. The fund bets that the dollar will deflate against a basket of currencies, including the euro, yen, British pound, Canadian dollar, Swedish krona and Swiss franc.
Brynjolfsson is particularly bullish on the Canadian and Australian dollars, as these countries also sell large quantities of commodities that should increase in price as the value of the U.S. dollar declines.
At the time of publication, Catherine Holahan did not own or control shares of any company or fund mentioned in this column.
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