Rising Expectations

Federal Reserve officials struck a positive note in the Federal Open Market Committee minutes released on Wednesday, stating that economic data indicate that growth should resume in the second half of the year.

Today’s nonfarm payrolls report showed that the unemployment rate ticked up from 9.4 to 9.7 percent after the economy lost 216,000 jobs in August.

Nevertheless, other economic data appear to bear out the Fed’s positive near-term outlook. The ISM Manufacturing index turned positive for the first time since January 2008 in August, reaching 52.9 and indicating a moderate increase in activity. Pending home sales also posted respectable increases on both a month-over-month and year-over-year basis, reaching 3.2 percent and 12.9 percent respectively.

As signs continue to point to recovery, the question of inflation becomes more pressing.

With the true cost of the US bailout efforts running into trillions of dollars and central banks engaging in quantitative easing, the specter of inflation looms large for investors and policymakers. The real question is whether our monetary and fiscal decision-makers will cut off the easy money in time to contain inflation.

Our elected officials have three options going forward: raise taxes and interest rates, cut programs and spending, or allow inflation to reduce the value of our debt. The first two choices are politically fraught, no matter which part is in the ascendancy. And judging by the contentious debate surround health care reform and the host of other problems facing our nation, no reelection-minded politician will go down either of those roads.

The path of least resistance for our leadership is to allow inflation to quietly take hold; that way no one is answerable for anything.

Now is the time to begin insulating your portfolio against this eventuality.

An obvious starting point is to build a position in Treasury inflation-protected securities (TIPS). Over the past year these investments have lost a little over 1 percent, but performance has improved as risk-averse investors gird their portfolios against future pain. Investors can purchase new issues directly from the US Treasury at www.treasurydirect.gov, or in the secondary market through any broker.

Another good option is to purchase shares of a TIPS mutual fund or exchange-traded fund (ETF). Our favorite mutual fund in the category is T. Rowe Price Inflation Protected Bond (PRIPX); iShares Barclays TIPS Bond Fund (NYSE: TIP) is our preferred ETF option.

The iShares ETF is extremely straightforward, holding a laddered portfolio of TIPS and tracking the Barclays Capital US TIPS Index. Formerly a consistent dividend payer, payments halted last November due to the falling pace of inflation. That situation is likely to reverse itself in coming months, as a rising Consumer Price Index (CPI) is almost inevitable.

T. Rowe Price Inflation Protected Bond isn’t quite so plan vanilla. Required to keep at least 80 percent of assets in TIPS, manager Daniel Shackelford has almost free rein over the remaining assets. That flexible investment mandate enabled the fund to outpace its benchmark and yield just over 1.3 percent, while the TIPs market suffered amid lower inflation expectations.

More adventurous investors could also opt for short-term, high-quality bond funds. As inflationary pressures build, the value of income streams generated by long-term bonds declines, pushing down bond prices. Short-term bond funds avoid the worst of those effects, enjoying quicker price appreciation and rising income streams.

To that end, one of the best short-term bond ETFs available is the iShares Barclays 1-3 Year Credit Bond (NYSE: CSJ). At the shorter end of mid-duration, the fund maintains an average credit quality of A and has the flexibility to invest in a variety issues. Well- diversified and yielding in excess of 4 percent, the fund boasts a miniscule expense ratio of just 0.2 percent.

The ETF obviously poses more credit risk than a government fund, but holding almost 350 issues leaves it well insulated against defaults.

It’s always possible that our government may prove itself more responsible this time around than it has in the past, but until we see definitive action it’s always prudent to hedge your exposures.