The minutes of the last meeting of the Federal Open Market Committee (FOMC) were released Wednesday and the central bankers of the world's largest economy made a note of the extremely benign situation in inflation. Core prices for personal consumption expenditures have risen just 1.2% over the last year, nowhere near the Fed's target and well under their historical average.
As a consequence, gold and other inflation-protection investments have plummeted and investors are questioning the need to buy insurance against rising prices. Making your own portfolio decisions, you need to ask yourself, "would I cancel my homeowner's policy just because I have not had a fire in a few years?" Long-term investors should note these five reasons to buy inflation protection now and how to protect a portfolio from surging prices.
The insurance that's cheapest when you don't need it
Unlike other insurance policies, where your premiums continue at relatively stable amounts, buying inflation protection now is fairly cheap. That's because the market is not expecting pricing pressure to increase much more than 2% over the next year. Take advantage of the discount to protect yourself before expectations increase.
When inflation increases it takes lending rates with it. While banks can make new loans at the higher rates, their older assets may take a hit. The rise in rates may also hit the still recovering housing market and Wells Fargo (WFC), as the largest U.S. lender, could get hit harder than other financials if inflation jumps higher. The $225 billion bank announced Wednesday that it would cut 2,300 jobs from its mortgage lending business through the rest of the year. Implied volatility for options on shares of Wells Fargo are low at 21%. This means that investors can protect a position by buying puts for the right to sell the shares if the price comes down. Buying the January $40 puts for $1.25 protects the shares from anything below a 9% decline.
History shows that inflation is fast and can get out of hand quickly
Since 1965, consumer inflation has increased more than 1.7% on top of the previous year's number in six years. The growth in inflation jumped 4.8% in 1974 to a total loss in purchasing power of 11% for the year. Even the highest rates in recent U.S. history do not compare with historical inflation in other countries like Germany in the 1920's where prices doubled every 3.7 days.
The loss of almost a third the value in the SPDR Gold Shares (GLD) since late last year is still strong in investors' minds but don't forget that it took just eight months in 2011 to tack on 40% to all-time highs. Analysts from Bank of America are predicting gold will reach $1,495 in the fourth quarter, a jump of more than 10% from current prices, on strong jewelry demand in China and India.
Money has never been easier
Over the last 47 years, consumer inflation has been over 2% for 40 of those years and has topped 5% in 13 of those years. The fact that we are at pricing pressure of just 1.2% despite an amazing amount of liquidity being pumped into the system is extraordinary. The Fed's balance sheet has more than quadrupled in the last six years to $3.64 trillion and they are adding $85 billion to the market every month. If that were not enough, Japan is bent on doubling its central bank assets over the next two years and has targeted inflation that is more than twice the current level. Rates are at historic lows across the developed world, all we need is lending growth to drive circulation of funds and kick start inflation.
Philip Morris International (PM) is a favorite of mine, not only for its 4% dividend but also for its protection against global inflationary pressures. The company can pass through higher commodity prices and smokers will keep coming back for more. The company has 16% of the international market and is making strong progress in China. Asia accounts for 36% of sales, followed by the EMEA region (27%), the EU (26%) and Latin America/Canada (11%). Shares have posted an annual return of 15% since its spinoff in 2008.
Stagflation is a very real possibility
Gluskin Sheff Chief Economist David Rosenberg has just changed his long-running forecast for deflation to one where inflation picks up. Rosenberg argues that consumer deleveraging has run its course and that central banks may soon be getting more than they bargained for in their inflation targets. Put the scenario for higher prices up against U.S. economic growth of just 1.7% last quarter, and barely positive in the European Union, and you have all the ingredients for stagflation.
The outlook for weak or no growth and rising prices could send investors herding for inflationary protection. In a stagflation environment, your inflation bets may be the only ones that offer any kind of return. If this were to happen, consumer discretionary names like the VF Corporation (VFC) might be good candidates to sell. The $21 billion apparel company has some fairly strong brands like North Face, Vans and Wrangler but not enough brand identity to pass through higher commodity costs without losing customers. Besides rising prices, sluggish economic growth means fewer people will be updating their wardrobe as often. Revenue growth slipped to 15% in 2012 and is seen at just 6% for this year.
Weaker dollar equals higher inflation
While the index value of the dollar against its major trading partners has increased to 83 from a low of 73 in 2011, it is still down more than 16% from 2003. The currency may be partly supported by a boom in energy extraction but sky-high fiscal deficits mean that the long-term trend remains intact. As the dollar weakens, inflation increases from more expensive imported products. Buying inflation protection can help mitigate the loss in quality of life from a more expensive basket of foreign products.
Buying shares of foreign companies, where most assets are denominated in the home currency may help mitigate the loss to the dollar. Potash Corporation of Saskatchewan (POT) has been hit along with other potash producers on threats that the global oligopoly will no longer be able to control prices. Potash has six mines in Canada, where the currency should hold up relatively well against the U.S. dollar. The company pays a healthy 4.7% dividend and rising demand for food and agricultural products should help support potash prices.
Perhaps the best reason for buying inflation protection is to think of it as insurance. The premiums on your home or car may not be a large portion of your total expenses but they can save you from financial ruin. The investments you buy for inflation protection do not have to be large allocations but can help sustain your portfolio in the event of higher prices.