As the Federal Reserve Board reiterates its intention to keep interest rates near zero into 2015, it appears that the markets and many investors are growing complacent about inflation. Ever since the Financial Crisis of 2007-08, “headline inflation,” as measured by the Consumer Price Index (CPI), has stayed low – so far. Although it has threatened to break out at times, economic weakness has restrained the price growth that underlies inflation.
Most investors know that interest rates are at multi-decade lows. Most short term money markets are paying a fraction of 1 percent; mortgages, Treasury bills and inter-bank lending are offering rates at or near lows that haven’t been witnessed in many generations, if ever. What could make interest rates go higher faster than the Fed’s wishes? One oft-frightening word – inflation.
We are seeing the signs that inflation and increased demand may be lurking around the next corner, indicators that could eventually lead to increases in interest rates and a higher long-term real rate of inflation in the economy.
While the Fed does have a certain amount of control over interest rates, the markets are likely to react negatively to any spikes in inflation, driving interest rates higher. This may force the Fed to take some action either to increase rates or raise its targeted inflation rate above 2 percent.
Incipient Inflation Widespread?
Headline inflation has stayed within or below the Fed’s inflation targets during the past few years. Recently, however, global pricing trends suggest that there is a certain amount of incipient inflation in the global economy, just waiting to break out. Weak worldwide demand has kept those inflationary flickers suppressed - so far; but as the US economy strengthens and emerging market consumers buy more goods and services, we expect to see inflation on the rise.
Just as demand is experiencing a long-awaited growth spurt, a wide variety of commodities are becoming scarcer. Crude oil and gold are becoming ever more challenging to find and the geographic areas where they exist are subject to growing political instability. Similarly, demand for food continues to expand, but availability is failing to keep pace stymied by erratic weather patterns, poor planning and other factors. As well, key industrial components, including rare earth and precious metals, have tight capacity.
Examination of the Producer Price Index (PPI) trends points to evidence of underlying inflation, quite another story than the CPI would lead us to believe. The PPI, which measures the output of selected industries and reveals pricing trends, has been increasing at a rate twice as fast as the CPI, which was depressed by falling housing prices. Now that the housing market has stabilized and those prices are no longer falling, the CPI could move up aggressively. It’s likely that in the next year or two, inflation will eventually stabilize at a rate of 3.5 to 4 percent, twice as high as the 1.5 to 2 percent rate of recent years, a major upward move.
During the global financial crisis, financial modeling based on historical behaviors failed. These historically-based models were unable to account for the multiple unforeseen events that cascaded over each other. In finance, a “Black Swan” is defined as an “unexpected event of large magnitude and consequence”. With interest rates at or near zero, the only direction a “Black Swan” event can drive interest rates is higher and the speed with which these rates spike can only get faster. Going forward, we could encounter such Black Swan events again: While we can’t predict the unpredictable, events like a re-emergence of the debt crisis in Europe, a major storm in the Gulf of Mexico that takes oil capacity off line, saber rattling in Russia, more political unrest in the Middle East or a crisis for US and European banks could push the needle higher. A confluence of such events could erode consumer and business confidence and roil markets.
Inflation Hedges Offer Potential to Insulate Portfolios
In an environment of rising inflation, a number of strategies can potentially protect investment portfolios. Traditionally, markets fall during times of rising inflation; and should the Fed backtrack on its promise to keep rates low through 2015, any increase in interest rates and subsequent pull back in liquidity will likely impact equity markets negatively.
In the world of hockey, former professional player and Coach Wayne Gretzky has been quoted as saying “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.”
Now may be the time for investors to go to where the metaphoric puck will be and take actions to help prepare for higher market volatility, preserve gains and limit losses by seeking out potential inflation hedges.
It makes sense to implement measures to protect investment portfolios in an effort to get in front of the curve as the prices on these hedges may increase more quickly once higher inflation takes hold. Currently, the prices of many of these assets are depressed due to profit taking in late 2012, making it appear to be an ideal time to invest.
Traditionally, investors have turned to “hard assets” to hedge against inflation, as they tend appreciate as fast as or faster than inflation. In our opinion, inflation hedges may be found in precious metals, livestock and companies in the agricultural and natural gas industries. Precious metals, particularly those that have industrial uses such as platinum, could do well in addition to gold and silver. Livestock, too, may have a place, as stocks are low in response to higher grain prices. We expect farmers to be a group that will increase spending in 2013, so companies that make products farmers use, such as irrigation systems, fertilizer production and specialized agriculture equipment look promising. With the natural gas boom in the U.S., opportunity exists for companies that specialize in infrastructure including natural gas pipelines and liquefaction facilities.
Going forward, protection from downside risk is an important priority. If inflation rises as expected, markets will be more volatile, which is almost certain to negatively impact portfolios. Strategies that may help protect portfolios in volatile markets include taking a good look at alternative investment classes, instituting rolling stops on portfolio positions, purchasing options and taking profits.
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