Is Inflation Around the Next Corner? Then What?
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. 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.
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 to ward off any crippling market events.
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. 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.
In an environment of rising inflation, a number of strategies can potentially protect investment portfolios.
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.
Traditionally, investors have turned to “hard assets” to hedge against inflation, as they tend to 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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