Inflation: The Next Crisis, And How To Protect Your Investments

Includes: CYS, GLD, RWT, TBT
by: Angad Guglani

Over the last two decades, inflation has been largely a non-issue. Sure, there were times when inflation crept up a little over 5%, but even that is a far cry from 12% we saw in the late '70s. You may ask, why has inflation been tame as of late? I can tell you one thing, it is certainly not hawkish sentiment from the Fed. Over the last three years alone the Fed's balance sheet has more than tripled to over $2.8 trillion! Not to mention that the benchmark interest rate has been below 1% for four years and is currently at 0.25%.

So why have prices of goods not risen? Recently the answer has been quite obvious: We have been in and recovering from one of the greatest recessions in history. As you learned in Econ 101, a recession can cause deflation due to less demand for goods, increased saving, and rising unemployment. Aside from the recession, there is a larger force at play, and that is the advent of globalization and technology.

Globalization and technology have made companies far more efficient, and therefore reduced the prices of goods they produce. For this reason, the prices of goods has remained stable despite a weaker dollar. The Fed has seen the stabilization of the prices as a sign that they can indeed print more money to "stimulate" the economy without excess inflation.

That is about to change. As China and India become industrialized, U.S. companies are no longer able to source their products as cheaply because cost of doing business in those countries is increasing. Examples of this are everywhere, such as the wage growth in China, where wages have already risen 10% this year. This is causing the resurgence of American manufacturing, which has lead much of the job growth for the last few quarters - meaning that higher prices are on the way for many goods.

As a famous adage states, there is no such thing as a free lunch. In the future we will be forced to pay for the over-exuberance of the Fed. It is not a question of if this date of reckoning will come, but rather when. It will be twice as painful because not only will prices of goods go up organically in real terms because of the industrialization of China and India, but also because of all the cash the Fed has pumped into the system during the recession.

There are a few ways to protect yourself from the inflation that is likely to ensue. The first is and foremost is to sell your bonds! With the 10-year note yielding a paltry 1.47%, bonds will surely be a losing investment. Even at current inflation rates of 3%, a holder of a 10 year treasury will take a 15% loss in real terms. Assuming that interest rates go up to 6%, which is quite possible, a bond holder will lose a little under 40% in real terms. Investors not afraid of risk may want to look at shorting bonds, which can easily be done through an ETF such as ProShares UltraShort 20+ Year Treasury (TBT).

For risk-averse investors I would suggest looking at income-producing assets such as real estate, which can be bought in the form of a high-yielding REIT such as CYS Investments (CYS) or Redwood Trust (RWT). Lastly, you may want look into gold (NYSEARCA:GLD). Personally I would not invest in gold as I prefer income-producing assets and find gold's value to be largely speculative (for further reading, see "Gold: A Commodity Or A Currency?"), but gold does serve as a fair proxy for the inflation trade.

Disclosure: I am long TBT.