Don't Let Rising Inflation Become The Bane Of Your Portfolio

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Includes: IDU, IYF, IYH, IYJ, IYK, IYM, IYW
by: Amit H. Shah

Summary

Inflation is expected to increase in the near future, and as a consequence, interest rates will increase.

Certain industries like the financial, utilities, and industrial are more insulated against higher inflation.

Investing in an ETF that shorts the performance of long-term treasury bonds will also be profitable in a fiscal environment of increasing interest rates.

Inflation affects even the sturdiest of currencies and slowly erodes its value. Money that is idled in a savings or checking account loses value over time due to inflation. Equity investing, on average, offers a better return on investment, and may offset losses from inflation. In a fiscal environment where inflation is high, certain sectors and individual companies are likely to fare better than others. This idea is explored using correlational analyses between inflation rates and sector-specific and company-specific performance.

Looking at the graph below of the inflation rate over the last century in the US, the current inflation rate seems very tame compared to historical inflation rates. So, what makes me think that inflation rates are on their way higher?

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At a more basic level, what causes inflation to increase? Economists generally think that a high inflation rate is a side effect of large increases in money supply. Let's look at an example of this outside of the United States. One of the worst cases of hypertension in the world occurred in Zimbabwe under the Mugabe regime, beginning in 1998 and peaking in 2008, when the inflation rate was increasing at an incredible 8 billion percent per month. There were many reasons for this absurd hyperinflation, including: national policies that stunted economic development, large-scale corruption, and excessive printing of money to fund military efforts. A large cause was also subjective: there was increasingly less confidence in the value of the currency.

The U.S. dollar, on the other hand, is viewed as being one of the safest currencies in the world to hold. This country is fortunate to have not gone through severe periods of hyperinflation (at least not since the Civil War), but there were periods of high inflation. From 1940-1952, for instance, inflation was relatively high, and peaked in 1947 at 14%. This is related to the large cost of World War II (1939-1945), and subsequently, of the Korean War (1950-1953). In order to finance these wars, the U.S. government increased income tax of its citizens, and also generated war bonds. The latter effort was voluntarily supported by half the country's population, and generated $186 billion, which is equivalent to $2.2 trillion today.

Inflation increased during the war itself, as raw material prices increased and price controls were enacted for many common goods sold, like rice. In many cases, price controls made the situation worse, as it created widespread shortages. Inflation continued to be a problem after World War II as the country tried to cope with its excessive debt. War-time spending during the Korean War added to the problem and to the country's deficit.

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The above graph shows U.S. federal deficit as a percentage of GDP. What is startling is that current levels of U.S. federal deficit are nearing those held during World War II. Similar to what happened then, military spending on the Iraq and Afghanistan wars is largely responsible for the current levels of federal deficit. An estimated $1.5 trillion has been spent on these wars since 2001, and additional costs of $2-4 trillion are estimated for the future. The subsequent financial crisis that occurred in recent times, requiring much financial stimulus, further added to the debt burden. Officially, nearly $900 billion was slated for the American Recovery and Reinvestment Act of 2009, but when TARP, bailouts, and tax rebates are all factored in, the total cost is estimated at $3 trillion.

Is there a relation between the federal deficit and inflation? See the chart below that plots both side-by-side:

Source: CBO.gov

Correlation analysis only shows a weak positive correlation (0.02) between the federal deficit and the inflation rate. Hence, a high federal deficit does not seem to be a good predictor of high inflation. But, these financial stimulus programs greatly increased money supply, which is a major underlying cause of inflation.

Quantitative easing may have aggravated the problem with excessive money supply. Quantitative easing was engaged in by the Fed starting in 2008 to improve the credit crunch situation, in which banks were reluctant to lend money after the financial crisis. Approximately $2 trillion has been spent by the Fed over 4 rounds of quantitative easing. This large infusion of cash is suspected to offset the ballooning federal deficit.

In a recent interview, Warren Buffett stated that, "there is no doubt in my mind that without financial stimulus, we would be much, much, much worse off that we are today. However, it is quite likely that we have now sown the seeds of inflation for many years to come."

Examining historical trends in the chart below indicates that there is a cyclical pattern to the inflation rate.

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Source: InflationData.com

As shown above, high inflation occurs approximately every 15 years. Inflation last peaked in 1980, and then trended downwards to a low in 1998. This suggests that inflation may trend upwards in the near term and peak in 2018. Historical trends may not accurately predict the future, but the headwinds created with large-scale increases in money supply by the U.S. Treasury and the Federal Reserve and the ballooning federal deficit seem hard to ignore. That being said, it is hard to predict when inflation will increase and how severe it will be. In any case, it will be beneficial to think about investments that will perform well in a high-inflation fiscal environment.

Industry Analysis and Inflation

Before delving into specific companies, let's first examine what sectors perform well when inflation rates are high. To analyze this, I looked at iShares US ETFs in the following sectors: Basic Materials (NYSEARCA:IYM), Consumer Goods (NYSEARCA:IYK), Healthcare (NYSEARCA:IYH), Financials (NYSEARCA:IYF), Industrials (NYSEARCA:IYJ), Technology (NYSEARCA:IYW), and Utilities (NYSEARCA:IDU), and correlated each of their average monthly price to the monthly inflation rates from 2000-2014. The graph below shows inflation rate (right Y-axis) and ETF prices (left Y-axis) from 2000-2014.

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Source: Yahoo Finance

A correlation analysis between each of these industries and the inflation rate is more revealing. Surprisingly, the highest correlation with inflation rates was for the financial industry (+0.45), followed by the utilities industry (+0.27), industrials (+0.19), the basic materials industry (+0.17), and the technology industry (+0.16). The healthcare industry (-0.01) and the consumer goods industry (-0.04) had the weakest correlation with inflation rate.

It is possible that the financial industry performs well during periods of high inflation, since this is when interest rates are also typically increasing in order to bring inflation rates down. Banks profit from rising interest rates, as the spread between what they earn by investing deposits and the costs of paying interest on those deposits improves.

Other defensive industries like utilities, industrials, and basic materials also fare well when inflation is high. This could be because the demand for these industries is relatively inelastic, and even when our earnings are negatively affected, we still need to spend the same amount of money on gas and electricity.

While these trends are revealing, the accuracy of the relationship between inflation rate and performance in these industries is difficult to determine based on the relatively short time period examined (2000-2014). However, this was the extent to which I could find historical prices for the chosen ETFs. This information does set the stage for what specific companies make for good investing opportunities in a high-inflation fiscal environment. These companies are likely to be in the industries highlighted in the above analysis.

Strategies for Combating Inflation and Profiting from Rising Interest Rates

  1. Invest in industries highlighted above that are expected to perform well during rising levels of inflation. This can be done at an industry-wide level through the ETFs highlighted above, or at a company-specific level. For instance, one ETF for the financial industry is IYF, and its major holdings are shown below. IYF is ~25% off its all-time high, and has room to grow as the economy rebounds and inflation as well as interest rates increase.

Top 10 Holdings (39.3% of Total Assets)

Company

Symbol

% Assets

Wells Fargo & Company Common St

(NYSE:WFC)

6.69

Berkshire Hathaway Inc. Class B

(NYSE:BRK.B)

6.53

JPMorgan Chase & Co. Common St

JPM

5.96

Bank of America Corporation Com

(NYSE:BAC)

4.50

Citigroup, Inc. Common Stock

(NYSE:C)

4.09

Visa Inc.

(NYSE:V)

2.89

American Express Company Common

(NYSE:AXP)

2.25

American International Group, I

(NYSE:AIG)

2.19

MasterCard Incorporated Common

(NYSE:MA)

2.11

U.S. Bancorp Common Stock

(NYSE:USB)

2.09

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Source: Yahoo Finance

  1. Invest in ETFs that are shorting the performance of long-term U.S. treasury bonds like TBT. The relationship between the 10-year treasury interest rate and TBT is shown below, and clearly, the performance of TBT is positively correlated with the long-term interest rate. The reason for this is that as the interest rate increases, the yields on new treasury bonds increase, making the older ones at a lower yield less attractive, and hence, their price decreases. Hence, shorting the older bonds is profitable in a rising interest rate environment.

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(Source: Google Finance)

The performance of this ETF has decreased in value by ~80% since 2008, but should rise with increasing interest rates.

Conclusions

Investments are a powerful way to protect savings from inflation; but, appropriate analysis needs to be done in order to identify the industries and strategies that are likely to perform best in a high-inflation fiscal environment. Both historical inflation trends and factors like high federal debt as well as increased money supply indicate that inflation rates will be higher in the near future. Correlation analyses between individual industries and the inflation rate suggested that the financial, utilities, industries, and basic materials sectors perform best when the inflation rate is high. Hence, investing in these industries is likely to pay off in the long term as inflation increases. A similar correlation analysis can be extended to find individual companies within each of these industries that will perform well in a high-inflation environment. Another strategy to doing well in times of increasing inflation and subsequent increasing interest rates is to invest in ETFs that short the performance of long-term U.S. treasury bonds like TBT. It is inevitable that interest rates, which have been held at a low level for a long time in order to stimulate the economy, will increase in the future. It is currently estimated that the Federal Reserve will begin to increase interest rates later this year or early next year. I hope that these investment strategies will stimulate your interest in thinking ahead and preparing yourself for a changing macroeconomic environment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.