The Safest Way to Fight Inflation

Inflation. It’s something that investors haven’t had to contend with for a long time. If anything, deflation has been the bigger concern. But that all changed on November 8. Since then, inflation fears have been roaring back in a big way.

Just look at some of the headlines.

“Dollar Strength will continue as Trump Policies Fuel Inflation”

“Fed May Have to Raise Rates Faster to Keep Up With Inflation”
— Morningstar

“US Inflation Expectations Gathering Steam”
— Financial Times

Higher Inflation Under President Trump
— Business Insider

GDP, Inflation and Interest Rates Forecast to Rise Under Trump
— Wall Street Journal

“Trump Victory Prompts Fund Managers to Focus on Inflation”
— Reuters

Merrill Lynch recently surveyed the nation’s mutual fund managers and found that 85% — nearly nine in ten — see rising inflation on the horizon. That’s the highest conviction for inflation in 12 years.

The core thrust of their argument goes something like this…

[ad#Google Adsense 336×280-IA]Trump’s tax cuts and fiscal stimulus spending will unleash economic growth, which tends to push prices higher.

At the same time, after years of remaining stagnant, we’re also starting to see real wage growth as the labor market tightens.

Finally, proposed trade barriers and import tariffs may bolster American manufacturing jobs, but they will also exert further upward pricing pressure on many products.

It’s still early, and policies enacted in office rarely match the rhetoric on the campaign trail.

Still, it won’t take much to move the needle. Current inflation rates around 1.25% are historically low, so we don’t need gusty macro tailwinds to drive them higher — a gentle breeze would do it.

The consensus among a poll of 57 top economists is for inflation to pick up to 2.2% in 2017 (from about 1.6% this year) and accelerate to 2.4% in 2018. That’s above the Fed’s comfort zone, so the central bank would be compelled to act.

Fed Chair Janet Yellen has already said that further interest rate hikes after the recent boost this month are likely in 2017.

Higher interest rates attract inflows into dollar-denominated assets, which is why the dollar has been surging against foreign currencies to the highest levels in a year (the implications of which we will be discussing in future issues).

Inflation is the enemy of bonds, as it erodes the purchasing power of their fixed income stream. Longer-dated securities are generally more vulnerable. Just talk of inflation has been enough to decimate the U.S. bond market over the past few weeks, wiping out more than $1 trillion in market value.

As fixed income investors, my subscribers and I over at High-Yield Investing have to be particularly vigilant to the threat of inflation. There is a useful forecasting tool that I like to use in this environment. Simply put, it gauges future expectations by subtracting the yield on 10-year inflation indexed government bonds from those on ordinary 10-year Treasury Bonds.

That differential — which essentially measures the breakeven level — jumped from 1.73% on November 8 to 1.82% on November 9 and continues to widen. If actual inflation rates over the holding period exceed 1.82%, then the inflation-protected bonds would offer superior returns. Anything less than 1.82% and the ordinary bond would do better.

Remember, economists are predicting inflation to reach 2.4% within the next two years.

Fortunately, Treasury Inflation Protected Securities (TIPS) are just one way for investors to combat inflationary pressures. Hard assets like gold can be a reliable hedge. The playbook also calls for increased exposure to cyclical stocks, whose fortunes ebb and flow with the economy — and whose dividends can rise to keep pace with inflation.

In the table below, you’ll find a few low-cost ideas that I recently presented to my premium readers at High-Yield Investing.

These yields don’t exactly reach out and grab you. But just like municipal bonds, there is more here than meets the eye.

TIPS offer lower upfront yields, because these securities have built-in inflation protection features. In essence, they offer a type of insurance policy against inflation — and the yield figures you see reflect the cost of that insurance.

In the case of the 10-Year TIPS mentioned above, that cost amounts to 1.82% annually. If inflation exceeds that amount, you win. And keep in mind, we are in an era of unusually low inflation — it has run closer to 3% a year historically.

With an ordinary bond, you are stuck with the fixed payments. But TIPS make semi-annual interest payments based on the principal. And while the coupon doesn’t change, the underlying principal is linked to the consumer price index (CPI).

The faster inflation heats up, the quicker the principal value resets higher — and the greater your interest payments. At maturity, bondholders receive the greater of either the original or the adjusted principal amount. That means these securities will always preserve the purchasing power of every dollar you invest.

That’s important, because many of Trump’s policies (infrastructure spending, immigration reform, protectionism, etc.) all point to inflation. Each of these funds will offer some degree of protection, but I give the edge to Western/Claymore Inflation Linked Opportunities (NYSE: WIW).

WIW is an actively-managed closed-end fund that has been in operation for over a decade. The portfolio is leveraged (meaning greater upside in favorable conditions) and judiciously spread among 99 different holdings, mostly AAA-rated inflation-protected government securities. Monthly distributions are set at $0.0335, which puts the yield at 3.3%. But 2% annual inflation could boost returns past 5%.

Bottom line: This is an asset class my High-Yield Investing subscribers will likely revisit in the not-too-distant future. By combining the safety of securities like the ones mentioned above with our usual portfolio holdings of securities that yield well above the market average, we’ll ensure that we will not only earn more income than the average income investor — but we’re protected from the negative impact of inflation.

— Nathan Slaughter

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Source: Street Authority