Holding an allocation to stocks that benefit from rising prices and bonds that are protected from inflation is an important strategy in meeting your long-term financial goals.
IN THE AFTERMATH of the worst financial crisis in 70 years, inflation has remained tame due to a slow growth environment and weak consumer demand. While policymakers have debated the potential for an onset of rising inflation, the traditional measures of rising prices, which exclude volatile energy and food prices, have been at or around 2% for some time. This level is considered mild and is unlikely to prompt an increase in short-term interest rates from the Federal Reserve. In fact, the central bank has said it is not likely to raise rates until at least mid-2015.
Nonetheless, a number of economic factors both in the U.S. and overseas could, over time, bring about inflation pressures. These include a significant rise in consumer spending, an uptick in hiring, or a major rebound in housing prices. In the global economy, higher wage pressures in emerging markets, which we have seen in recent months, could also push prices higher. "Inflation is tame today," says Tim Parker, portfolio manager of the T. Rowe Price New Era Fund (PRNEX), which invests in companies that own or develop natural resources. "But certain economic conditions around the globe may drive prices higher in the future and affect investments—and we're extremely mindful of those forces."
HEDGING AGAINST RISING PRICES
While investors cannot know when rapid inflation may occur, they can take steps to hedge against the potential effects of rising prices. One method is by maintaining a portfolio with an appropriate allocation to stocks that generally benefit from rising prices and higher interest rates, such as dividend-paying stocks and stocks of natural resources companies. Many fixed income investments do poorly in a climate of rising prices because bond prices generally decline as interest rates go up. However, some fixed income securities—floating rate funds and Treasury Inflation Protected Securities, for example—are protected from higher inflation and interest rates because their yields or value rise with rates.
Market volatility stemming from the financial crisis has prompted some investors to increase their fixed income allocation to
offset the perceived greater market risk of stocks. But that move—shifting to "safer" asset classes, with limited potential
for growth in principal or coupon payments—increases your exposure to the long-term threat of inflation, which can erode the
real rate of returns of your investments over time.
INFLATION: YESTERDAY AND TODAY
Thomas Rowe Price, Jr., was ahead of the curve when he wrote a report entitled The New Era of Inflation in the late 1960s. Notes Parker, "Mr. Price asked a fundamental question: How do you defend a portfolio from inflation?" Price's response was to create the New Era Fund, which invests in shares of companies that benefit from rising prices. At the time of the fund's inception in 1969, Price invested in computers, industrial automation firms, and discount stores, among others. A decade later, inflation hit 13%, and investors benefited from the fund's diversified allocation.
Inflation in the U.S. has averaged about 2% over the last five years, near the Fed's preferred rate. Factors in both the domestic and global economy, however, suggest prices could rise faster in coming years: In addition to a possible rebound in consumer demand and wages, high debt levels and loose monetary policy in the U.S. and Europe, coupled with the large U.S. trade deficit, have increased the money supply, which in turn can drive inflation higher. Employment remains weak throughout the developed world, restraining labor costs—an important input to prices. Eventual tightening of job markets in the U.S. and Europe could accelerate wage increases, which could also cause prices to move higher. Meanwhile, wages in China, where low labor costs helped depress prices worldwide for the last decade, are rising quickly.
Over the next quarter century, up to three billion consumers are expected to join the middle class in China, India, and Latin America.1 While inexpensive and plentiful natural resources helped fuel global economic expansion in the 20th century, population growth and increased demand in emerging economies will likely drive prices higher.
"Emerging markets have driven great demand for base materials over the past 10 years," Parker says, noting that China has been heavily importing iron and steel to build the infrastructure it needs to serve big industry and large projects. "Now we're starting to see more demand from emerging market consumers. We take for granted in the U.S. that we can have strawberries in January. Emerging markets consumers don't assume that yet. But as they enter the middle class, they will."
When strong demand for a commodity confronts a limited supply, costs usually rise sharply—a basic economic dynamic that has occurred in recent years when growing demand and poor harvests produced sharp increases in global food prices. Food costs can significantly affect inflation in the short term, especially in emerging economies. That's because consumers in emerging markets spend, on average, a much larger portion of their incomes on food than people in developed markets.2