Worries About Inflation

The United States has enjoyed a long period of relatively tame inflation and either steady or declining interest rates. This environment has lent itself well to investing in equities and predictable returns in debt securities for conservative or income-oriented investors. Recently, however, disturbing signs that more aggressive inflation may be on the way have begun to worry the markets. The predictable response of the Federal Reserve has been to tighten the money supply.

The global trends that drive the re-emergence of inflation are not so much cyclical as they are event-driven. This time the threat derives from the obvious insatiable demand for petroleum, along with the persistent weakness of the U.S. dollar and emerging Asian demand for goods and services. Ongoing government spending required by hurricane reconstruction projects and military spending in the Middle East also are major factors.

Conventional investing wisdom dictates that high and rising inflation requires refocusing asset classes into value-oriented investments with steady predictable returns and low volatility. The investing strategies applicable to the past decade have left many portfolios with low exposure to inflation-fighting investments; presumably a quick review of the traditional techniques is in order.

Inflation-protected securities are one available choice but there are other suitable vehicles when the goals are maintaining a positive return above the prevailing inflation rate, low volatility and a risk level approximating long-term Treasury securities. These include the following:

Real Estate and REITS
Real estate investment trusts (REITs) let investors participate in the real estate market without owning real property outright. There are a variety of REITs that specialize in office, apartment, retail and industrial properties. The rents and net profits they generate generally increase in an inflationary period, so their returns keep pace with other prices. Keep in mind, though, that substantial increases in real estate prices over the past several years may make real estate investments a risky gamble at this time if the bubble bursts.

Commodity Securities and Precious Metals
A commodities index fund can provide broad and diversified exposure to the global commodities market with less risk and complexity. Look for funds that specialize in energy, agriculture and livestock, industrial metals, and mining and raw materials, such as paper and forest products. For efficient investing in gold and other precious metals, consider exchange-traded funds (ETFs).

Selected Equities
Financial stocks should do well, and most banks should show reasonably good earnings (provided their revenue stream has shifted to service charges and other noninterest income sources). But banks that have not done a good job of matching assets and liabilities for interest rate sensitivity will suffer. Energy stocks should continue to reap benefits from high prices. Consumer and household-oriented stocks, especially companies with a handle on costs, should prevail.

Avoid companies that are significantly reliant on debt. The health care industry, a traditional performer, is in a period of volatility and should be scrutinized carefully. Ditto for pharmaceuticals, although generic drug producers should reap the rewards of increasingly cost-conscious consumers. Growth stocks (including technology) are vulnerable because higher interest rates make their future earnings much less appealing, and because they typically depend on debt as a source of cheap financing. The monumental losses created by hurricanes Katrina and Rita remind us that domestic property-casualty stocks are another sector to avoid when low risk is the goal.

Choosing a proper portfolio requires extensive consultation and discussion with clients. The question of whether the inflation monster has returned is being debated by economists on both sides of the issue. As always, diversifying a client’s portfolio is key.

—Raymond Cobos, CPA/PFS, is manager of practice management and Web development in the Financial Planning Specialty Area of the AICPA. Mr. Cobos’ views, as expressed in this article, do not necessarily reflect the views of the Institute. Official positions are determined through certain specific committee procedures, due process and deliberation.