Inflation is certainly a significant risk for investors in 2013 and beyond. But as I’ve mentioned before, I think it’s too soon to make significant changes to a portfolio based on inflation fears as I don’t expect to see a sharp spike in inflation this year, for a few reasons:
First, despite a recent rise in bank lending, most of the extra stimulus money created by the Federal Reserve is still sitting on bank balance sheets. Also, as this money starts hitting the supply, there will likely be a lag before inflation hits. Historically, it has taken about two to three years before growth in the money supply has translated into a meaningful acceleration in inflation. And while the Fed recently slightly raised its inflation forecasts through the end of 2014, even Fed officials are saying that they expect inflation to remain low.
Even so, many investors are still worried about rising prices and are looking for inflation hedges. For these investors, the chart below provides a nice look at how various investments stack up when it comes to preparing a portfolio for inflation.
Click to enlarge
Not surprisingly, Treasury Inflation Protection Securities, or TIPS, come out on top. However, it’s important for investors to keep in mind that while TIPS provide an effective inflation hedge and having a benchmark allocation to this asset class is prudent, the many investors clamoring into TIPS are currently contributing to, and accepting, an average negative real yield across the entire TIPS curve. In addition, TIPS will not perform well if real yields rise along with rising interest rates.
What are your preferred inflation hedges?
TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses.