As governments around the world have engaged in deficit spending in order to combat the financial crisis, concerns have arisen regarding what effect this spending will have on global inflation. Investors are asking what they can do to protect themselves if and when a significant increase in inflation occurs.
The first issue to address is whether or not we can expect all of this spending to necessarily lead to higher inflation. While conventional “wisdom” suggests that inflation is inevitable under the current scenario, the economic data do not support this view. It is crucial to keep in mind that there are many factors other than government spending that affect inflation, such as unemployment, productivity, and capacity utilization, and these factors may very well conspire to keep inflation in check. We must also remember that our economy was recently in a dangerous deflationary mode, so a moderate increase in inflation would be a welcome event. So, while some economists do acknowledge that the risk of an unwelcome inflation surprise is higher than normal, after all of the competing factors are taken into account, most economists and the capital markets are not expecting a dramatic increase in inflationary pressures due to the recent deficit spending.
That said, it is still necessary to consider how we can protect ourselves in the event that a large increase in inflation does occur. If we wait for inflation to materialize and make adjustments to the portfolio at that time, it will be too late (this is the investment equivalent of buying insurance on your home after it burns down). Heritage therefore prepares client portfolios for inflation before the actual evidence of inflation is present. We address the risk of inflation on two levels – short-term and long-term inflation risk.
We can partially hedge against short-term inflation risk via the use of our bond portfolios. We allocate a significant portion of our bond portfolios to U.S. Treasury Inflation Protected Securities (TIPS), which are directly linked to the increase in the level of the Consumer Price Index (CPI). As consumer prices increase, the face value of TIPS increase. In addition, we invest most of the non-inflation protected portion of our bond portfolios in shorter maturity bonds. In an increasing interest rate environment, when these short-maturity bonds come due, they can be re-invested at a higher rate of interest. While these two strategies do not constitute a perfect inflation hedge, they do provide a significant level of protection.
The best way to hedge against longer-term inflation is by investing in assets that can be expected to increase in value as the general level of prices rises over time, such as equities and commodities. Equities will most certainly respond negatively to a sharp increase in inflation over the short-term, but over longer time periods equities, like commodities, tend to offset the damage caused by rising prices in the overall economy.
So, although runaway inflation is far from certain, we have prepared our client portfolios to offset some of the adverse effects in case a sharp rise in inflation does occur. We hope this helps to clarify some of the issues surrounding inflation, and as always, we welcome your questions, comments and suggestions for future topics. |
