Confronting Inflation, The Thief in the Night
William McChesney Martin, chair of the Federal Open Market Committee (FOMC) during the 1950s, summed up his attitude at one FOMC meeting: “Inflation is a thief in the night and if we don’t act promptly and decisively we will always be behind.”
A thief in the night is a wealth destroyer, but one against which you can implement simple precautions. You can lock the doors to the house. You can add an alarm system. And if you’re so inclined, you can buy a gun. (For home defense, I prefer a Louisville Slugger.)
Inflation, though, is a much more insidious thief. Protection against rising prices requires greater finesse.
Inflation acts as a hidden tax that doesn’t show up on your annual IRS return. In many ways it is a tax, because it partly results from flawed monetary or fiscal policies. We can “insure” ourselves against the effects of that stealth tax, but it can be tough to decide just how much insurance is necessary. Below, I’ll examine inflation protection measures you can take now.
CPI runs hot, again…
The U.S. Bureau of Labor Statistics reported Wednesday that the consumer price index (CPI) jumped by 7% in the year through December, and by 5.5% after excluding volatile prices such as food and fuel (see chart).
The last time the main inflation index hit 7% was 1982. In the latest CPI report, increases in the indices for shelter and for used cars and trucks were the largest contributors to the all items increase.
Bolting the doors against inflation…
The most critical principle to consider when creating an inflation protection strategy is your risk tolerance, which is usually defined by how close you are to retirement.
The rule of thumb is, the closer you are to retirement, the more inflation protection you should have. There is no “correct” formula for all investors.
Those close to retirement should pursue a diversified approach, adopting various types of inflation hedges, and at the protection levels consistent with their risk profiles and liabilities.
A proven inflation protection tool are U.S. Treasury inflation-protected securities (or TIPS). TIPS are tied to the CPI; when the CPI goes up, the principal values of TIPS rise, too.
Investors are increasingly scooping up TIPS, recent data compiled by Bloomberg show. Fueling the buying frenzy are worries that inflation protection could become prohibitively expensive as the price of these instruments are bid higher.
In addition to low-cost TIPS, I recommended that your inflation protection strategy includes a diversified mix of commodity and real estate stocks, as well as emerging markets exposure. By increasing your stake in developing economies, you’re protecting your assets from the risk of a U.S.-centric versus global inflation shock.
Gold, poised to shine…
Roughly speaking, the following portfolio allocations make sense under current market conditions: 25% cash, 40% stocks, 25% hedges, and 10% bonds. Make sure your hedges sleeve contains hard assets.
About 5%-10% of your hedges sleeve should contain gold, the traditional inflation hedge. The value of gold tends to increase as the purchasing power of the dollar declines.
The price of gold currently hovers at around $1,800 per ounce, roughly where it was 12 months ago. That means gold prices are historically undervalued and they’re set to perform far better in 2022. Some analysts expect gold to hit $3,000/oz by the end of this year.
My preferred way to profit from increases in gold prices is through small-cap miners that can put corporate operating leverage to work.
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