The definition of inflation is the rate at which the general level of prices for goods and services rise, and subsequently, purchasing power is falling. As inflation rises, every dollar will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of Skittles will cost $1.02 in a year.
Inflationary pressures in the US are currently muffled due to recent government efforts to jumpstart the economy (e.g. the US government’s recent $787 billion spending legislation). This has fueled and raised the prospect for higher inflation in the coming years.
So, what asset classes does an investor want to look for in an inflationary environment? Three that come to mind:
- Commodities – generally, real assets (i.e. things that are tangible, like gold, oil, or timber) tend to perform well during inflationary periods. This is a result of inflation of prices being associated with the real assets.
- Inflation-Adjusted Debt Securities – a.k.a. TIPS (Treasury Inflation-Protected Securities) can be attractive as the bonds are structured to provide returns that adjust for inflation. Principal value is adjusted semi-annually based on CPI (Consumer Price Index, a widely quoted measure of inflation). The coupon rate for TIPS is constant, but generates a higher level of interest when the inflation-adjusted principal rises, thus protecting the holder against inflation.
- REITs – Real Estate Investment Trusts generally own physical structures and property that maintain value during inflationary periods. Apartment buildings, office towers, and shopping malls tend to be less influenced by rising inflation than paper-based monetary assets.
Why didn’t stocks make the cut? In short, as a whole, they don’t do as well in an inflationary environment. However, let me be clear, there are a lot of stocks that do perform well in inflationary periods, it just takes some discernment as to which ones. Proper research must take place, and probably a professional money manager should be consulted.
We must all be aware that while there are signs that alert us that inflation MIGHT occur, it isn’t a guarantee. It is simply on the horizon (I’ve heard perhaps a 2-5 year time frame). That is a lot of time for some leading experts to come up with ways to combat it, and of course, for our government to weigh in on the topic…joy joy.
Ultimately, diversification is key, in any market phenomenon. Building positions gradually in a basket of multiple, non-correlated assets that historically have offered some protection against accelerating or high inflation may help reduce the performance drag that often accompanies these periods.
Sources: MARE group, www.investopedia.com