What Does Gold's Rise Mean for Inflation?

Includes: CVX, DCP, EXC, GG, LNGG
by: Roger S. Conrad

“No Inflation in Sight” asserts a headline in Friday’s Wall Street Journal. Looking at the most commonly used indicators of prices, it’s hard to argue.

The Producer Price Index (PPI) for August did rise 1.7 percent, topping a consensus expectation of just 0.8 percent. But that was following a 0.9 percent decline for July. And leaving out volatile-priced food and energy, the “core” PPI rose just 0.2 percent.

As for the Consumer Price Index (CPI), it rose 0.4 percent in August, up from 0 percent in July. But again, leaving out food and enrgy, the core CPI rose just 0.1 percent.

Despite a torrid run since early March, commodity prices also appear to confirm a trend of disinflation. The broad-based Dow Jones UBS Commodity Index is up almost 10 percent in 2009. But it’s also down nearly 25 percent over the past year and is 30 percent below its 52-week high.

Finally, benchmark interest rates are still very low. The 30-year Treasury bond yield is again scraping close to 4 percent, even as the benchmark 10-year yield is still under 3.5 percent. Investment-grade corporations are borrowing at their best rates in decades and interest rates on 30-year mortgages are back around 5 percent. The widely watched London Interbank Offered Rate (LIBOR) rate, which at the peak of last year’s credit crisis was well over 4 percent, is now just 29 basis points.

However, one historically reliable indicator of inflation--gold--is flashing red. Over the millennia of human history, empires have risen and fallen and their fiat money has vanished. But the yellow metal has held its value throughout.

Last year gold broke out to a new high of more than $1,000 an ounce, only to plunge back to around $700 in the wake of the financial crisis. This week, after several months of strong and steady gains, it’s surged again, breaking past $1,000 and hitting a new all-time high.

Gold’s run-up hasn’t gone unnoticed by the market. Institutions as well as individuals are reportedly taking positions in the metal at an unprecedented rate. Even Yahoo! Finance, which long ignored the gold market, has begun posting the per-ounce price of the near-term futures contract (currently September 2009) on its home page.

The question is what does gold’s rise mean for inflation, and therefore for income investments.

From 2003 to 2007, inflation fears stirred every spring and early summer like clockwork, triggering a spike in interest rates and a corresponding selloff in prices of income investments from utilities and bonds to real estate investment trusts.

Every summer, those fears were eventually quelled. Interest rates headed lower again and income investments rallied, wiping out the previous losses and in most cases moving on to new highs.

The summer 2007 rate spike, however, was the last straw for the over-leveraged housing and financial sectors. Rates did come down sharply in the latter half of the year and prices of financially strong income investments--particularly utilities--actually rallied to new highs by early 2008.

But since that time the bad news on the credit risk front has far outweighed any good news on inflation. And even income investments backed by secure, recession resistant businesses have been sold off.

As I’ve pointed out in recent issues, credit risk is still a big deal for some sectors of the US economy. Credit card default rates are still rising along with unemployment in most of the country.

The housing market has shown some signs of stabilizing, with construction nationwide actually rising over the past month. But reports have also surfaced that the Federal Housing Administration (FHA) is running low on cash, due to the massive burden it’s taken on as effectively the mortgage lender of last resort.

Credit risk, however, has become a non-issue for the well-heeled. Solicitations from lenders are back on the rise for those with top credit scores. Meanwhile, many investment-grade corporations are borrowing at better rates than they were in early 2007, when money was still flowing free and easy.

Last week, for example, Exelon Corp (NYSE:EXC) issued 30-year debt at a spread of just 200 basis points to Treasuries, increasing the offer when demand exceeded expectations. That will enable the utility to further cut interest expense by refinancing higher-cost debt.

At the peak of the credit crisis there was no market for non-investment-grade securities. Today, that market too has unfrozen. From its early March low, my favorite high yield bond fund Northeast Investors Trust (NTHEX) has nearly doubled in price, as the value of its holdings has recovered and management’s skill at picking survivors has paid off.

The sharp decline in credit risk has started to be reflected in the prices of other income investments as well. Prices and yields, however, are still much higher relative to the benchmark 10-year Treasury note.

That suggests continuing skepticism about the global economy. It also means investors are still unwilling to wade too deeply into what are still perceived to be dangerous waters, despite quite bullish polls on market sentiment.

Until this skepticism vanishes most income investments are going to continue trading at a discount to Treasuries. That means we’re still going to see rock-solid utilities paying yields of over 6 percent, energy infrastructure focused master limited partnerships (MLP) paying out 8 percent and up, and the safest Canadian trusts dishing out over 10 percent. Anything perceived as riskier is going to yield even more.

As long as that’s the case, income investments are going to benefit when the news is good on the economy and sell off when the news is bad. That’s in stark contrast to, for example, the traditional trading pattern for utility stocks, which has been counter-cyclical. But as long as investors are worried about the economy, it’s a relationship that will prevail.

Do surging gold prices indicate inflation is making a comeback? We probably won’t be able to answer that one for a while. But one thing the yellow metal’s strength does indicate is the debasement of the US dollar after a year of unprecedented “quantitative easing” to head off depression, as well as the fact that the US is no longer the world’s only major market for raw materials.

The US dollar has continued to act a lot better than many investors thought possible. For one thing, it’s still viewed as a safe haven, which attracts buyers when worries about the global economy crest again. But these remain powerful headwinds that could have a substantial negative impact on income investments, as well as increase the costs for Americans traveling overseas.

The foundation of my income investing strategy for the past two decades-plus has been managing two basic threats: credit risk and inflation risk. Again, the former has been the primary concern over the past couple of years. But inflation has never been far from my thoughts either.

Happily, the first key to avoiding the worst of both is to focus on securities backed by healthy, growing businesses. Healthy growing businesses not only hold their dividends in tough times, they increase them. Their bonds and preferred stocks earn higher credit ratings, or are redeemed at substantial premiums.

In contrast, those who are lured by a high current yield into buying a weak business will experience, at best, stagnation and erosion of value in the face of inflation pressure. At worst they’ll be the victims of dividend cuts, plunging share prices and, as we’ve seen more than once over the past year, potential bankruptcies and total wipeouts.

Buying only from good businesses is as essential to surviving future inflation risk as it’s been to surviving credit risk over the past couple of years. But it’s only one of the ways that income investors should protect themselves.

Equally important is maintaining diversification and balance. My approach is to own securities issued by first-rate businesses from a range of sectors. If you want to get current income, you have to buy and hold long enough to collect the interest and dividends.

And, while some successfully implement “dividend capture” strategies that allow them to sell after the payment is assured, they’re always getting hit by the tax code.

Buying and holding, however, means being able to absorb the inevitable ups and downs of the market in the near term. A healthy, growing business will gain market value over time, but stocks rarely, if ever, move in a straight line. Odds are there will be plenty of volatility along the way.

If you’re investing to build wealth, such moves are largely irrelevant. But if you’re living off those investments, you can’t afford to be in the position where you have to eat your seed corn--that is, being forced to sell good positions at rock-bottom prices to raise needed funds.

Obviously, there are times when you can’t help when you sell. But by diversifying among many sectors and keeping the dollar value of your holdings roughly balanced, you can ensure that your overall portfolio maintains a certain baseline value where funds will be available.

Even during the past year, when investments across the board were being dumped, there were bright spots in the market that held value. Vanguard GNMA (VFIIX), for example, holds only the very safest securities, low-duration government-based mortgage securities. As a result, the fund barely registered a scratch during the worst of last year’s crunch. For anyone in need of funds who owned it, it was a life-saver.

Gold is about the best insurance against a future bout of inflation, as it basically is money. On the other hand, few gold investments actually pay dividends. Aside from peace of mind and potential capital gains, the metal does little for income investments.

There are solid gold stocks such as Goldcorp (NYSE:GG) that pay modest dividends, and I recommend every income investor own some as insurance. But it’s impossible to get around the fact that an income portfolio loaded with precious metals will be a low-yielding one.

Fortunately, energy provides a hedge that’s almost as good, and there are plenty of investments offering high yields, from MLPs to Super Oils and Canadian royalty trusts.

It’s impossible to imagine a surge in inflation without a corresponding rally in energy prices. Consequently, well-placed energy investments will not only keep pace with any future inflation, but their gains will almost certainly exceed it and therefore make up for inflation-related losses elsewhere in portfolios.

Super Oils are perhaps the safest energy bet, mainly because their balance sheets are stronger than those of most countries. Those with rising production profiles, like Chevron (NYSE:CVX), offer the best values.

As those who dialed in to Thursday’s conference call learned, there is a wide range of MLPs that offer varying exposure to energy prices. The purest plays for producers is Linn Energy (LINE), though that MLP has basically pre-sold its next three years’ output at premium prices.

MLPs with substantial gas gathering assets, DCP Midstream Partners LP (DPM), for example, also provide energy price exposure, but with the cushion of cash flows from fee-generating assets that keep dividends safe.

Canadian income trusts and high-yielding corporations provide an additional form of hedge, thanks to being priced in and paying dividends in Canadian dollars. Canada is one of the world’s foremost natural resource exporters. As a result, the loonie is at its core a petro-currency. When oil prices rise, so does the value of the Canadian dollar, handing an effective dividend increase and capital gain to US investors.

If inflation raises its ugly head, even trusts and corporations that aren’t involved in energy production will benefit from a rising Canadian dollar. And healthy businesses will perform best of all, as they grow and generate rising dividends on their own.

Those interested in this area of investing should check out Maple Leaf Memo, a complimentary weekly e-zine co-edited by myself and David Dittman.