Don’t Get Burned by Inflation
I disagree with the inflation alarmists who warn that federal stimulus will overheat the economy and trigger ruinous inflation. I think the nation’s main task is to dig out of the economic hole created by the coronavirus pandemic. If anything, the biggest risk would be for policymakers to play it too cautious in their fiscal and monetary remedies.
That said, there are signs that inflation is rising. We’re probably not entering a long-term cycle of major inflationary pressures, but prices are indeed edging higher. The Fed expects inflation to run at a modest 2.2% this year. You should take protective measures, now.
As inflation and interest rates rise in the coming months, you may be tempted to abandon bonds altogether. That would be a mistake. I explain why, as well as pinpoint a bond fund appropriate for this investment climate.
Knowing that rising interest rates wreak havoc with bonds, it’s logical that the single worst one-year period for bonds was 1980, when the federal funds rate whipsawed from 14% to 8.5% then back up to 20%. In that year, the aggregate return on bonds was -15.5%, as investors struggled to get a handle on the direction of interest rates.
But bonds don’t always react adversely to increases in the federal funds rate. Examining the trailing one-year returns of 10-year Treasury bonds, bonds tend to hold their own even when the interest rate edges higher.
The worst 20-year period for bonds was between 1961 and 1981 as the fed funds rate climbed higher from about 2% to 20%. Over that period, the aggregate return on bonds was -40.8%. Inflation soared in the 1970s, as the following chart shows:
The stock market collapse of the early 1970s is instructive. By 1968, economic growth and the stock market had been rising, with only minor hiccups, for two decades. Prosperity would continue until the 1973-1974 bear market, when stocks across the board got crushed.
What triggered this bear market? The federal government was paying for Great Society social programs, while at the same time spending vast sums to fight the war in Vietnam. All without raising taxes. The Arab oil embargo also played a role, by hiking energy costs. The Watergate scandal brought political risk.
Moreover, unlike the jobs equation today, globalization was less pronounced in the 1970s and labor unions still had strong (albeit waning) clout, all of which fueled wage growth. Inflation (as measured by the Consumer Price Index) spiked from 3.4% in 1972 to 12.3% in 1974. A recession hit, spawning stagflation. It tool Federal Reserve Chair Paul Volcker’s tough medicine in the form of sharp interest rate hikes to finally kill inflation in the early days of the Reagan era.
Interestingly, in the four instances that 10-year Treasuries had a negative return in the 30 years between 1983 and 2013 (1987, 1994, 1999 and 2009), the fed funds rate was only on the rise in 1994. Over the course of that year, the fed funds rate rose from 3.25% to 5.5%, wiping out more than $600 billion of the U.S. bond market’s value
Why did the bond market wipe-out occur in 1994? After economic growth and relatively tame inflation in the early days of the Clinton administration, commodity prices started rising and ignited inflation. In response, the Fed tightened interest rates by 25 basis points. The move came as a shock and the hikes kept coming.
In 1994, investors had grown accustomed to a low interest rate environment and ignored signs of economic overheating. The rate hikes came like a bolt out of the blue. While interest rate increases are generally harmful to the value of fixed-income securities, bonds take the worst hit when those increases are unexpected. This time around, the Fed does not have an itchy trigger finger. The U.S. central bank has vowed to maintain its dovish monetary policy well into the future, even during transient inflation spikes.
Your portfolio should hold bonds as ballast. They add diversification and a steady stream of income. That’s particularly true when you own well-diversified bond funds whereby managers can spread their bets and upgrade their holdings as the investment climate changes. Consider adding bond funds that offer interest rate and inflation hedges to your portfolio. Which brings me to the following bond fund.
WIP inflation now…
SPDR Citi International Government Inflation-Protected Bond ETF (WIP) seeks to provide results that correspond to the price and yield performance of the Citi International Inflation-Linked Securities Select Index.
The index is designed to measure the total return performance of inflation-linked bonds outside the U.S. with fixed-rate coupon payments that are linked to an inflation index.
With net assets of $405.4 million, WIP provides exposure to inflation-linked bonds of developed and emerging market countries outside of the U.S. As such, this exchange-traded fund (ETF) should hedge your portfolio against the erosion of purchasing power due to overseas inflation.
The fund holds a basket of about 100 foreign, investment-grade, inflation-protected bonds. These are repriced according to inflation levels in those countries, and all of the holdings are priced in currencies other than the dollar.
The fund currently yields 3.72%, but if global inflation rises or the dollar weakens, the yield will rise as the value of the payouts increases. The fund is one of the best dollar hedges you can find.
WIP’s top countries in terms of asset weightings include the economies of Germany, United Kingdom, Chile, Colombia, and Spain. That’s a buffer against risk in any single nation or region.
Because it’s invested in government debt outside of the U.S., WIP offers the solid protection of highly rated bonds. It’s also a bet that inflation will be generally higher outside of the U.S. than within the U.S., which has typically been true in this century.
I expect strong returns, combined with inflation protection, from this ETF in 2021 as massive fiscal stimulus and easy money fuel inflation.
I don’t expect inflation to get out of control over the long haul, but I do expect temporary spikes as the recovery picks up steam. Every portfolio should hold protection against inflation in its hedges sleeve. With a reasonable expense ratio of only 0.50% and a yield of 1.64%, WIP does the trick.
Another effective inflation hedge is gold. At least 25% of your portfolio should be devoted to hedges. As part of your hedges sleeve, about 5% – 10% should be in precious metals, notably gold.
I prefer gold mining stocks to physical bullion or funds. To find out why, click here for our special report on gold. Our report pinpoints an exciting small-cap gold miner that’s on the verge of explosive gains.