What to do about the coming inflation (if it comes)?

[samclem]

Well, I'm way overdue for my portfolio review and rebalancing, but am doing it now. We've discussed possible impending inflation due to the huge slug of money dumped into the economy by the government--when the velocity of money picks up again, these bucks will be used to buy a relatively unchanged quantity of goods and services=higher inflation. Of course, the fed could take steps to bring this money out of circulation--all of which would put a damper on growth, possibly during an election year. Unlikely

So, what's a rebalancing investor to do?

TIPS, TIP funds, gold, oil, other currencies: there are plenty of options out there. The article here does the best job I've seen of explaining the pitfalls of each.

- TIPS and TIPS Funds:
-- May not accurately reflect your own inflation (where's CFB when we need him!)
-- The value of existing TIPS could take a huge hit once the Fed raises rates. Or, if they have to raise rates because investors are increasingly concerned about getting repaid their money. So, inflation is raging, but the value of your TIPS (or TIPS fund) is plummeting because the govt is issuing new bonds (maybe including TIPS) which pay a higher rate than yours. Not much protection. Only buying an actual bond and holding it to maturity will avoid these problems.
- Gold and Gold mining:
-- Poorly correlated to actual inflation in the past.
-- When the fed raises rates, gold prices will go down as people seek higher fixed returns and have reduced concerns about future inflation (regardless of what is actually happening to prices at that time) .
- Commodities ETFs and funds
-- For esoteric reasons, the futures contracts many deal in can get driven down in price even when prices, and expected future prices, for the underlying commodity are going up (today's new word: "contango")
-- If economic activity decreases while inflation rages, there'll be less demand for many commodities, so their prices will stay steady or decrease.

Okay, so there are no "silver bullet" solutions out there to protect against inflation in all scenarios. Our options, as I see them (comments/criticisms solicited):

A) Diversify across these types of inflation insurance: Buy some of each and hope that you'll be protetced by something in the particular inflationary environment that comes next.

B) Make a bet. Try to guess which might do best. Right now, if I had to bet I would buy some exposure to energy stocks. If the dollar devalues, oil is likely to keep the same value and be worth more of the devalued dollars. Sure, if industrial demand goes down then oil prices will go down somewhat, but they'll come back. Over time, world demand for energy of all kinds is going to mushroom. I'm not worried about the windmills and PV panels.

c) Fuggedaboutit: Don't try to outsmart the inflation guessers. The expectations about possible upcoming inflation are already built into the price of any "insurance" you could buy. Just own a bunch of diversified stocks. They generally do well in keeping up with moderate inflation. You'll own some things that do well in high inflation (REITs, etc) and some things that might get hurt, but overall things will go okay. Stocks don't do well in "crazy high" inflation (which disrupts the financial markets and business cycles), but at that point we're in a whole new ballgame--guns, ammo, dried food and small gold coins.

How are you addressing this? I'm leaning toward Option C, but a small bit of Option B might help address the need to feel like I'm doing something about the potential problem.

 

[REWahoo]

Sam, I chose c and, in a salute to unclemick's testosterone theory of investing, a tiny smidgen (less than 2% of my total portfolio) of b.

I'm smart enough to know I'm not smart enough to outguess those who are trying to guess.

 

[calmloki]

Regarding inflation: this morning we were updating our net worth (ooo - gold's up!) and noticed that our net worth had gone up by about 50% as we updated. Amazing what entering Johnson&Johnson stock price as $6609 versus $66.09 can do! I agree that inflation looks like a no-brainer and feel that there's just no way that oil prices won't be heading skyward over the next decade. For me, a commodity that earns income seems smartest - rental real estate. I don't think REITs have the bang for the buck that private holdings do, but owning & managing your own places is a lot like work. Maybe A&C? The shotgun approach has some merit...

 

[Animorph]

I'm going with no bonds, 50%+ international exposure, energy/natural resources stocks. All part of my normal asset allocation. Plus I just did a cash-out refi at 4.375% 30-year fixed rate that I could be paying back with inflated dollars.

 

[Midpack]

I agree that inflation looks like a no-brainer and feel that there's just no way that oil prices won't be heading skyward over the next decade.

I have a small stake in VGENX for the same reason...YMMV. I also have VGSIX (REIT), but I agree with your ho-hum assessment of their near term potential.

 

[FIREd]

I am doing A mostly. I have a mixture of TIPS (my personal inflation is way below CPI so no worries), short term bonds and CDs, commodities (gold, silver and CCF fund), real estate, foreign currencies (cash and equities) and... a j*b. Hopefully it will be enough to reduce or negate the potential damage caused by high inflation to the rest of my portfolio. But quite frankly I am still not convinced that high inflation is the most likely scenario, so I don't want to overdo it.

 

[FinanceDude]

Time to lose the "if inlfation comes", and update it to "WHEN" inflation comes. Washington is looking at a 2nd stimulus package, so the Treasury printing presses will be running overtime for quite some time to come.

Maybe all those folks in CDs will quit whining in a couple years.........

 

[samclem]

Maybe all those folks in CDs will quit whining in a couple years.........

The folks now buying 5 year CDs at 3% APY will be jumping out of them pretty fast (penalty or not) if the march upward starts next year.

How bad could it get? In 1981, 6 month CD's had an APY of 15.79%

 

[Midpack]

How bad could it get? In 1981, 6 month CD's had an APY of 15.79%

Boy, I'd have to go "all in" on CD's (or a big chunk anyway) at that rate...

 

[samclem]

Boy, I'd have to go "all in" on CD's (or a big chunk anyway) at that rate...

Yep, except that inflation was going crazy, topping out at an annual rate of 14.76% just the previous year, and no guarantee it wouldn't go much higher. So, it wasn't really a no-brainer, the return was very modest in real terms.

Still, if I ever see double-digit CD rates again, I hope I'll have the courage to buy at least one small one regardless of the inflation rate--just so I can have a story about it.

 

[W2R]

Sam, I chose c and, in a salute to unclemick's testosterone theory of investing, a tiny smidgen (less than 2% of my total portfolio) of b.

I'm smart enough to know I'm not smart enough to outguess those who are trying to guess.

C for me too, and although I am thinking/hoping this is what I should do, it's scary.

Perhaps because I am female, any testosterone type of investments that I have made have completely cratered in the crash and are still performing abysmally. Good thing this hasn't involved much money.

 

[Gone4Good]

I vote for A & C . . . diversify and fuggedaboudit.

- TIPS for inflation
- Regular bonds for deflation
- Domestic stocks for growth and because the US still kicks a$$
- International stocks for growth and because the US may kick a$$ less going forward

I've never been a fan of commodities. I think they're more of a hedge against inflation fear than actual inflation. And inflation fear is already quite high, so the prospects of future returns may be quite low.

I also have what is probably a minority view that CPI is actually a good measure of inflation. While it's not perfect and CPI will not specifically track my "basket of goods", I don't think it understates average inflation, or is manipulated, to the degree many people fear. So I think TIPS are a really good addition to a bond portfolio and probably the best inflation protection available.

Regular bonds win if actual inflation is lower than the market expects (Bill Gross is buying longer dated treasuries these days because he thinks low inflation is here to stay). TIPS win if inflation is higher than the market expects. Because I have no clue what inflation will be, I own roughly an equal amount of both knowing that either TIPS or regular bonds will have gotten it wrong to some degree.

 

[yakers]

I like the discussion and I like that there are different approaches. My primary pension is COLAd so I have less concern about inflation. DWs pension is not fully covered for inflation and, of course, our IRAs & investments are at risk. I have eliminated my primary domestic bond fund and increased foreign stock holdings, similar to Animorph in approach. Don't know how owning our house, mortgage free, fits into this but it is a residence as well as an asset. Oddly enough we will be cashing in our ibonds next year but this is to help pay for yonger son's college costs and the gains should be tax free.

 

[Meadbh]

Au, Ag, RRBs, oil stocks, rental real estate, fuhgeddaboudit.

 

[smjsl]

Hi everyone, I love these boards and have been reading up on them for some time. ER has been a dream of mine for a long time now but I never seriously investigated it until recently. I am still in accumulation phase and have some time to go. I was going to post a question on inflation but samclem beat me to it! Thanks!

Here are my views and questions on inflation...

First, since I want to plan for 40-60 years in retirement, it seems like dealing with high inflation (>10%) is a MUST, or I am taking too large a chance that the nest egg will just be depleted quickly enough during some time in the coming decades, whether it will happen due to current fiscal policies or due to some later ones. I'd say this is my biggest worry and I do not see any good solutions :-(. I don't care if I can beat the inflation - just looking for the most "guaranteed" way to keep up with it on after-tax basis for the minimum non-discretionary part of my retirement portfolio.

When I was younger (ok, maybe a month ago), my naive plan on dealing with high inflation was buying TIPS, I-bonds, and/or SPIA. Well, I-bonds have gone away for practical purposes with current 5-10k limits.

I have not investigated inflation-adjusted SPIA enough yet (I don't like potential company risk - need to look more into what is insured by goverment agencies and how much).

Now, I looked into TIPS and found a huge issue with them that noone seems to talk about... taxes. (Most of my savings are in taxable accounts even though I max out 401(k)/IRA) If I buy individual TIPS, say 20-year kind, I have to pay taxes on nominal adjustment each year even though I won't get the adjustment until maturity! So, if I am buying TIPS to protect me for inflation, and 10% inflation adjustment makes me pay 3.5% in today's dollars in taxes each year, the end result will only be 6.5%. Put simply, I'd lose as much as my tax bracket each year in real returns.

I assume TIPS funds do not save you from this since either me or the fund has to pay the same taxes, just like I would buying each individual security - IRS will get its money no matter what from these TIPS. (Am I missing something?)

<conspiracy paragraph>I don't know how CPI relates to my expenses (I started keeping careful track of my expenses recently and hope to find my personal answer to this in a few years). Still, even if current CPI adjustments are OK, I guess there is risk that one way goverment can deal with its debts is to tend to underestimate CPI for all the TIPS and other inflation-linked obligations. </conspiracy paragraph>

Now, gold is the inflation protection from permanent portfolio of Harry Browne (thank you to folks on this board by the way for this reference); but I think there are issues with it too. First, the low correlation of gold based on the linked article (thanks samclem) is a real bummer. I did not realize this is the case and may want to check on this more. Also, gold is based on perceptions only. It has no intrinsic value it seems beyond limited uses. Yes, it acts as nice "monetary" equivalent in terms of being non-perishable and divisible; but I guess more importantly, I come back to its only value as being historically the thing people go to when other currencies fail (or so I read somewhere). But I am bad at history and I am afraid of relying on it in this ever-changing world...
Also,
- as Mr. Browne himself acknowledges much of gold's power in 70's was due to its prior fixed pricing at $35 and this will no longer apply, and
- US goverment is known to have been confiscating gold in the past (I believe something like 4 times?), most recently in 1930's. I imagine if US did this, any goverment can (or am I too naive?).

From what I read, stocks do NOT protect from high inflation as was the case in 70's too for example and as another link from some older post explains (Buffett on inflation: http://www.chanticleeradvisors.com/files/107293/Buffett%20inflation%20file.pdf). So, general stocks in (C) is not really an option IMO.

samclem, you did mention "REITs, etc" for high inflation. Could you clarify on "etc"? I really want to know!

I think REITs is an interesting idea. Managing real estate would not qualify as "retirement" for me :-(, but getting exposure to it via REITs may work. At least REITs seem to be backed by something real which will hopefully appreciate in value a lot in 10% inflation environment. Can others point out biggest issues with REITs?

Next, commodities. I looked into them recently as well but I came to the same conclusions as the article - contango (which will be very likely in 10% inflation by the way when noone know how high it will get going further) will kill the ETF performance. And as Lehman example shows, ETNs is not a place where I want to keep my inflation hedges (if bank's promissory note is too much for it to pay, it can easily dissolve and in case of high inflation, it certainly sounds like it may put a strain on the bank to pay out those large ETN obligations).

Commodity-related stocks - I think this could be a maybe but remind me more of stocks inflation protection.

Energy-related stocks - I have those now but I think I will need to get out of them since I DO think alternative energies of one kind or another will become much more feasible in the next 10-20-30 years. (Too much discovery channel for me? lol) So, again, these do not seem like a retirement solution for 40-60 years.

Other currencies don't protect against inflation in those currencies. Same goes for foreign stocks. Too many countries are printing money nowadays and even if they don't now, they probably over the next few decades at some point... and I can't predict these things (nor do I want to try during my retirement).

Finally, at the risk of sounding like a total newbie (oh, wait, but I AM!), I heard about all those great 15% CDs when inflation was indeed a problem. Is CD ladder a solution? Even if they lag a bit, rolling over CDs into rates that give me same returns as inflation seems to protect me, does not it? Ok, the tax issue still applies (as with TIPS), but is there anything else? Reason to prefer CDs to TIPS perhaps is that it seems like CDs always have higher rates than TIPS... or would this change in case of >10% inflation. (Plus, and I can cash in CD for not too huge of a penalty and don't have to sell it like TIPS, potentially at large discounts.)


So, my summary so far:
1. Inflation is #1 deal breaker for 40-60 year retirement

2. Potential ways to deal with it but no good ones so far (ordered from safest real returns in high inflation to worst):
- I-bonds (only if they come back in reasonable amounts)
- CPI-adjsuted SPIA (cons: investigate more, may jump to end of list)
- CDs (cons: taxes will reduce the rates well below inflation; any others?)
- REITs (cons: need to find out correlation with inflation, nothing guaranteed about them like CDs, others?)
- Energy-related stocks, but for short term, not a real long-term solution
- TIPS (cons: taxes will reduce the rates well below inflation)
- commodity stocks (cons: too much like stocks and not like commodities?)
- gold (can be confiscated, history of 70s misleading due to prior fixed pricing, no intrinsic value / cash generation abilities). Maybe for historical reasons should have 2-3% of a gold ETF?

3. Totally ruled out:
- stocks (were shown to not do well with relatively high inflation)
- foreign stocks (carry risk of inflation in other currency and do not protect vs world inflation - and we are moving to more and more of a single system)
- commodities (ETFs have contango, ETNs have too much credit risk for when they can pay off big)

@samclem, did you have something else in mind besides REITs in your item (c) for high inflation case?

@Meadbh: sorry for missing orientation, but what do "Au, Ag, RRBs" stand for?

----
One last note: 10% is not a magic number by any means - many countries in recent history (including US) have gone through much worse inflation rates and did not have to go to guns & wars because of it - so that's the scenario that I think is likely enough to consider living through in the next 60 years.

 

[freebird5825]

Primary income source is also a COLAd pension, but I seriously doubt it will keep up with any extreme inflation explosions, if that happens.
VGENX, VGSIX and some I bonds are already in the long term portfolio.
My short term portfolio also stands ready to provide extra income (stop reinvesting dividends).
I already have a lot of extra cushion built into the budget, i.e. there are several discretionary items that could go away if necessary to severely cut costs.

 

[FIREd]

smjsl,

unfortunately, many inflation hedges are not tax-efficient and should be used in qualified accounts for best results. That includes TIPS, short term treasuries and CDs, commodities, REITs, etc... I decided against investing in VGENX because energy stocks behave more like other stocks than commodities. I personally prefer to use PIMCO's Commodity Real Return Fund for fighting inflation, especially because the fund uses TIPS as collateral and so the returns will likely keep up with inflation over time.

 

[samclem]

Welcome to the board, smjsl. That's quite a post.

To get on common ground--I think we might agree that "regular" equities (represented by the market as a whole) will provide adequate protection from mild inflation--companies will go on pricing their products higher as their costs climb, and thus their dividends and their share prices will continue to climb. It's only when inflation starts distorting the business cycle (I dunno--maybe inflation at a real rate of something more than 8%?) that the inflation itself starts affecting business in a major way, and therefore stock returns.

REITS: One would think they might be a good inflation hedge--after all, there's real stuff--usually commercial property--underlying them. But, if businesses are starting to suffer due to the effects of inflation (see above), how will the commercial real estate market be faring? Will the owners of those properties be able to command higher rents? That will be pretty important as interest rates on the underlying loans start to rise with inflation.

Here's a (very) brief article from Forbes, (Nov '08). They've covered much the same ground as we have. He likes short-term Treasuries. I would imagine short-term investments of other types (e.g short-term CDs, etc) would do about as well. None of these have been stellar performers over the long term producing far less return than stocks, real estate, or even longer-term government bonds. So, you'd probably be giving up some important long-term growth to have this inflation protection. It's insurance, and insurance can be expensive.

 

[audreyh1]

Well, I wish I had some references for you, samclem, but I don't see the Fed throwing money at the economy as necessarily being inflationary, because we are still in the middle of a lot of credit unwinding/deleveraging which has been pulling a great deal of money out of the system (which is deflationary).

The high inflation of the 1970s was driven mostly by wage inflation which is non-existent today due to globalization. I'm not sure what else would drive a major rise in inflation. Economic recovery? - well then we're looking at the lesser of two evils compared to a year ago. US currency lower than other countries? Not so sure how far that can go either, as other countries are dependent on US economic health and other countries have lots of debt too. Nevertheless, one can diversify globally.

Regardless of my outlook, I always choose option C. I maintain a small position in "hard assets" as a hedge, assuming that during most periods we are going to experience some degree of inflation. I just consider this "hedge" to be part of my diversification. I've never bought TIPs, as I always figured that game was rigged (although I believe PIMCO knows how to play that game to their advantage).

Audrey

 

[FIREd]

Well, I wish I had some references for you, samclem, but I don't see the Fed throwing money at the economy as necessarily being inflationary, because we are still in the middle of a lot of credit unwinding/deleveraging which has been pulling a great deal of money out of the system (which is deflationary).

The high inflation of the 1970s was driven mostly by wage inflation which is non-existent today due to globalization. I'm not sure what else would drive a major rise in inflation. Economic recovery? - well then we're looking at the lesser of two evils compared to a year ago. US currency lower than other countries? Not so sure how far that can go either, as other countries are dependent on US economic health and other countries have lots of debt too. Nevertheless, one can diversify globally.

I agree with you. I think that there are several ways in which inflation might not materialize. In addition to the systemic problems you outlined, the Feds could potentially soak up the liquidity fast enough to avoid major inflation (best case scenario). Or the Feds might also purposedly sacrifice some economic growth in order to kill inflationary pressures (by being preemptive rather than reactionary). Increasing taxes could also stifle growth prospects and put a cap on inflation. And of course, the recovery is still very fragile. It could be derailed at any time and send us back into another recessionary tailspin. I personally think that the risk of deflation is not insignificant for the next few years. That's why I prefer to be cautious and not over-hedge against inflation, at least not yet.

With all their stimuli, massive government borrowing and easy money policies over the past 20 years, you would think that by now the Japanese would be looking at some nasty inflationary pressures, yet they struggle to keep their rate of inflation positive.

So, given the wide range of possible outcomes, I think caution is key.

 

[heyyou]

A with a C attitude. Broad diversification including some of each of the inflation buffers then not worry too much about what I can't control. We will muddle through somehow. Maybe we will have to move somewhere cheaper someday, or travel less, or work at minimum wage jobs in late retirement. We will hit those points long after most of the rest of the population does. Neither the good times nor the bad times last forever.

To paraphrase Churchill, TIPS are not a good inflation hedge, but they are better than all of the other ways that have been tried. If the TIPS buyers don't trust the CPI-U numbers, that should eventually be priced into the rate.

Read an article years ago that named different causes of inflation, each with a different hedge as mentioned by other posters above. Energy price shocks are different inflation than gov't monetary policies, etc. One other hedge was just having a little more equities but I can't remember what specific circumstances that helped, maybe it was from having fewer bonds.

When rates are high again, think about how long term zero coupon bonds will vary in price. In the early 80s when my annual income was $30K, I skipped buying newly issued 14% zero coupon bonds because I was intimidated by eventually facing $60K a year of phantom income from the lot. Think what those bonds would be worth if they were throwing that much phantom income. Look at the big picture, not just the negatives as I did then. High inflation may offer you the opportunity of long term, guaranteed double digit bond income from your shrunken portfolio, if you will buy bonds when no one else likes them due to recency.

 

[semtex]

max out my mortgage and no prepay one cent

 

[Gone4Good]

max out my mortgage and no prepay one cent

But then the question is . . . what do you do with the money that would have gone to repay the mortgage? Are you any better off with a mortgage if your larger portfolio doesn't keep pace with inflation, or cover it's carrying cost?

 

[Gone4Good]

The high inflation of the 1970s was driven mostly by wage inflation which is non-existent today due to globalization.

I'll take this one further . . . NONE of the pre-conditions that caused stagflation in the 70's are present today. Low growth and high inflation were caused by supply shocks that lowered the country's non-inflationary growth rate (oil embargo, 70% marginal tax rates, wage & price controls, etc.). These things caused the country's supply curve to steepen and move to the left, resulting in both higher unemployment and higher inflation. Meanwhile, monetary stimulus pushed the demand curve to the right, which caused prices to increase further. But higher prices couldn't induce much of a supply response because of the the myriad of structure impediments to growth. So prices rise and unemployment stays high. Stagflation.

The current situation bears no resemblance to the 70's. What we're dealing with today is a demand shock, much like the 1930's. For too long aggregate demand was artificially inflated by cheap credit. Aggregate supply rose to meet that demand. Now a credit crunch and excess leverage has caused aggregate demand to fall precipitously. But productive capacity is still mostly geared to meet the peak demand of the credit boom. (i.e. the demand curve shifts to the left and the supply curve remains unchanged causing lower prices and lower output). In this environment, easy money can help increase aggregate demand without fear of causing inflation.

 

[semtex]

I agree, that's the key, whether i could beat 4.875%(my mortgage rate). As a DYI play, so far so good.