4 Ways Income Investors Can Protect Against Inflation

by: StreetAuthority

By David Sterman

"The cult of inflation may only have just begun."

That was a bold and eye-opening sentiment legendary bond fund manager Bill Gross expressed in the summer of 2012.

What on Earth is he talking about? After all, inflation has been declining for more than three decades and is nowhere to be found in today's economy.

But Gross has a point.

Inflation was virtually non-existent in the 1930s and the 1960s, but came roaring back in each of the subsequent decades. Will past be prologue?

There's a decent chance we'll eventually be prepping for a fresh bout of inflation for one simple reason: The Federal Reserve will eventually need to reverse course, unwinding its massive quantitative easing programs that have taken many bonds off the market. As the Fed pushes all of those bonds back into the market, many fear it will trigger an unwanted (though not unexpected) rise in bond yields and inflation.

Inflation is a pernicious beast. It eats away at the value of many assets like stocks, leaving many poorer in the process. In the 1970s, the S&P 500 rose less than 20% in value. Yet during that decade, inflation soared, meaning the inflation-adjusted value of the S&P 500 actually dropped by more than 25% (before dividends are accounted for). Indeed, traditional stocks always tend to fare poorly at times of high inflation (though it's worth noting that a modest move up in inflation from current levels would not necessarily be so deleterious to stocks).

Gold Bugs Rule

Fearing inflation's return, investors have flocked to gold, sending its price up from less than $500 in the middle of the last decade to a recent $1,675.

It's fair to wonder whether that stunning upward move already reflects any inflationary times to come. So rather than simply sit on a cache of the shiny yellow metal, you should take note of four other investments that are likely to hold their value if we return to inflationary times.

Here they are...

1. Commodities And Real Assets

Gold is just one of many commodities that tend to rise in price as the corrosive effects of inflation start to bite. Other precious metals such as silver and platinum have traditionally served as inflation hedges as well, as have other commodities such as copper, steel and grains. The cost to process these goods rises in inflationary environments, which producers must pass on to buyers. Even in a weak economic environment, these items can still rise in value as producers cut output to the point where historical processing profit levels are restored.

But the greatest hard-asset inflation hedge may simply be in housing. This is because home prices tend to reflect the cost of construction, with a built-in profit mark-up for builders. Inflation causes all of the materials and labor associated with construction to rise in price. Anyone who bought a home in the 1960s saw their investment surge in value by the 1980s thanks to high inflation -- even as their monthly mortgage payments stayed flat.

2. Foreign Stocks

Rising inflation tends to erode the value of a currency, as foreign-exchange traders shift funds to other markets where inflation trends remain in check. The absolute rate of inflation doesn't matter to them -- simply the direction. So even though Brazil's inflation is the 5% to 6% range, which is well above our own 2% inflation rate, currency exchange rates already reflect that. So if our inflation rises toward the rate of Brazil's, then the Brazilian real is likely to strengthen against the U.S. dollar. As a result, an investment in Brazilian stocks would be boosted by the strengthening local currency.

In recent years, the Australian dollar, the Swiss franc and the Brazilian real have all strengthened against the dollar, boosting the returns of U.S. investors in those markets. Which countries' currencies will appreciate against the dollar in the years ahead? It's hard to know, which is why a broad-based and balanced approach to foreign stocks is the wisest path.

3. High-Yield Bonds

Anyone investing back in the 1970s will tell you that bonds were the name of the game. Inflation began to move up (and eventually surpass) double-digit rates, but so did bond yields. Of course, any investor who owned bonds before the inflationary crisis of the 1970s missed out, and bond funds fell in value in the 1970s as bond yields soared. That's why it's a bit premature to seek out the inflation hedge of bonds now. Instead, keep an eye on inflation and rates in the years ahead. At some point in the years ahead, investors will likely be treated to robust yields in some of the safest fixed-income arenas again.

Investors can hedge against any inflation to come by buying high-yield bonds. These bonds, typically issued by companies that are just a notch below "blue-chip" status, already offer impressive yields.

4. Stocks With Rising Dividends

Of course, many companies operate in inflation-resistant industries. If prices rise, then companies like Coca-Cola (NYSE:KO), Anheuser-Busch InBev (NYSE:BUD) and Procter & Gamble (NYSE:PG) simply raise the prices of their own products. This enables these kinds of companies to boost their dividends at a consistent rate.

Let's look at how Coca-Cola performed in the 1970s. In 1970, the company paid out a dividend of $1.44 a share. By the end of the decade, that payout had risen to $3.92 a share (adjusting for a 2-for-1 stock split in 1977). That works out to be a 12% compound annual growth rate, which is even higher than that decade's inflation rate of 8%.

Risks to Consider: These various asset classes are also affected by other factors that influence prices. For example, real estate values have already begun to rebound prior to the appearance of higher inflation, but they could take a short-term hit if rising inflation took a toll on the U.S. economy. In this instance, it's important to see an asset such as real estate as a long-term inflation hedge, though it may not act as one in any short-term time frame.

The stock market has risen sharply since the early 1980s, in part because inflation has been steadily falling, making inflation-sensitive assets like bonds relatively less appealing. Yet this era may be coming to an end, so investors need to brush up on their options now.

As noted earlier, a moderate rise in inflation to the 3% to 4% range would not necessarily be bad news for U.S. stocks. Indeed, the move up on rates may be a signal of rising economic activity, which is a clear positive for stocks. But a move in inflation into the mid to upper single-digits would likely be a strong headwind for stocks. Simply put, stocks fail to hold their own, on an inflation-adjusted basis, when inflation is at abnormally high levels. That was surely the lesson learned in the 1970s.

Original Post

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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: StreetAuthority LLC owns shares of BUD in one or more of its “real money” portfolios.

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