Remember the good old days,” back when you could get 11% in a CD (of course your car payment was 17% and your mortgage was 14%)? Why were the rates so much higher back then compared to today? The reason was that the inflation rate at the time was so high that it forced the interest rates up as well. Today, let’s talk about inflation, if it’s a current threat to you and your portfolio, and how to invest your money if so.
First, what is inflation? In essence, inflation is the change in prices for a select “basket” of goods over time. This basket represents a price index. While there are many index baskets, the most common is known as the consumer price index or CPI. It is measured in terms of its % increase. Our current inflation rate is approximately 1.4%. The Federal Reserve uses monetary policy to manipulate interest rates to target an agreed upon “healthy” inflation rate. While some inflation is good, too much can cause the economy to slow down. The current Fed target is around 2% to 2.5%. When inflation gets too high, the Fed raises interest rates to slow the economy and therefore reduce more inflation. We have actually been measuring inflation back to the late 1700s.
How do we feel inflation? We feel it at the grocery store or the gas pump etc. It is our cost of living. Increases to our cost of living allow us to buy fewer goods with the same money. It is why Social Security increases payments most years, albeit not much. The inflation rate for the index is a function of what is in the “basket” being measured. As I mentioned before, there are many different baskets used to measure inflation and all of them can give you a different rate increase. It’s important to know which one the government is using because it can affect your cost of living increases. The stronger the economy, the higher the potential for inflation. We see this when a strong economy causes a reduction in unemployment. Low unemployment causes wages to go up. Higher wages lead to higher prices for products. This is the argument some use for not raising the minimum wage rate.
How does inflation affect your portfolio? The most obvious way is that it reduces the effect of your returns. If you earned 8% on your portfolio and the inflation rate was 3%, then your “real return” would only be 5%. Today we see this play out in fixed income rates. If returns for bonds for the next decade are around 2% to 3% and inflation is around 2% to 3%, then essentially you are making no real return on your fixed income. This is a very real possible scenario in my opinion. I have very low expectations for bonds over the next 10 years. Inflation causes you to pay more for your investments without getting any increased value for the price. Since inflation can be seen more dramatically in fixed income, many people look for alternatives to invest in to outpace inflation.
So how do you invest your money if you’re worried about inflation? Investing in stocks is the most common way since, historically, stock prices have outpaced inflation. For retirees, however, this is not always the most appealing option. What if I am a mostly fixed income investor? A popular option is Treasury inflation protected securities or TIPS. TIPS pay you back your principal based on the increase (or decrease) of the CPI. While this has become the seemingly default option for fixed income investors, I would argue that TIPS don’t really perform the way investors expect. TIPS have not always provided a great hedge against rising rates because they are more correlated to treasuries than people think. When you are trying to hedge something, you want the lowest or better yet negative correlation to whatever it is you are trying to hedge. Since TIPS are more correlated to treasuries, they aren’t as effective as some would hope. Stocks, commodities and CPI Swaps are all negatively correlated to treasuries with CPI Swaps being the least correlated of those.
So do I need to worry about inflation when the CPI has been so low lately? While perhaps not immediately, the answer over the longer term is yes. We are currently $26 trillion, yes trillion, in debt and this will likely, ultimately lead to higher inflation. I would suggest that if you are going to add investments to your portfolio to hedge against inflation, be careful which ones you pick since not all of them may perform the way you hope.
T. Eric Reich, CIMA, CFP, CLU, ChFC is president and founder of Reich Asset Management and can be reached at 609-486-5073 or email@example.com.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. To view form CRS visit https://bit.ly/KF-Disclosures.
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