In the 1930s, the U.S. government sought to boost a flagging economy by maintaining very low interest rates. Throughout the decade, consumers benefited by obtaining low-rate mortgages -- though their savings accounts garnered insultingly low levels of interest as well.
Sound familiar? Well, the government has been pursuing that policy in recent years as well, as the Federal Reserve has initiated a series of programs (formally known as quantitative easing) that aim to keep interest rates -- and inflation -- at very low levels.
Now concerns are growing that the steps taken to spark the economy will have negative long-term consequences and the current period of low inflation and interest rates will again come to an abrupt end. What will this do to your portfolio, and what can be done?
Bill Gross, the nation's top bond fund manager at Pacific Investment Management Co. (PIMCO), signaled just such a concern in a note to clients this past summer cautioning that 'an investor should continue to expect an attempted inflationary solution in almost all developed economies over the next few years and even decades,' adding that 'the cult of inflation may only have just begun.'
All this raises the question: What kinds of investments should be pursued in order to protect yourself (or hedge, as industry types would say) against inflation? The answer is not what you would expect. In fact, the speculative cushion some investors fall back on may not be the answer.
Potential Investments
Whenever the prospect of rising inflation rears its ugly head, many investors reflexively turn to precious metals such as gold and silver. Indeed, the move up in gold prices from $800 an ounce in late 2008 to a recent $1,670 coincides with the more aggressive steps taken by the Federal Reserve as 'gold bugs' began to fret about runaway prices.
But here's the problem: Gold is not really a hedge against inflation -- it is only perceived to be. If and when inflation starts to kick in, there's no clear-cut reason gold prices must move higher. In fact, gold has suffered from major sell-offs in past decades when inflation rose more slowly than had been feared.
Still, inflation is corrosive. It eats away at the present value of all assets. If you keep cash in the bank at a paltry 0.5% interest rate but annual inflation moves up from a current 2% to 4.5%, it's as if your banked cash is losing 4% of its value every year.
Do Your Research
That's why it pays to find investments that can hold their own when inflation reappears. And finding these opportunities is actually quite simple. You want to find any companies that have the pricing power to adjust or the hard assets that tend to serve as an inflation hedge.
Let's look at a few examples.
When it comes to making beer, Anheuser-Busch InBev (NYSE: BUD) feels the effects of inflation. Virtually all of its costs go up, from the raw ingredients such as barley, malt and hops to the fuel used in delivery trucks. But beer makers simply pass on those higher costs to customers and, as a result, have shown remarkably steady operating profit margins in periods of both high and low inflation.
Automakers have no such luxury. If they choose to raise prices, consumers may decide to stick with their existing vehicle a bit longer or they may check out lower-priced products made by foreign rivals. And thanks to a stream of government mandates regarding safety and fuel efficiency, car making has never been more complex or expensive. Still, car prices -- adjusted for the content in each vehicle -- have in fact fallen in value over the past decade on an inflation-adjusted basis. So a period of rising inflation may spell trouble on the profit front for automakers. But other investments adjust well with inflation.
You can extend this framework to virtually any industry. If you're concerned about an imminent upturn in inflation, focus on companies that have proven pricing power. Providers of consumer staples such as Procter & Gamble (NYSE: PG) and Colgate-Palmolive (NYSE: CG) always raise prices when their costs go up.
Consider this as well: Consumers may not realize that one of the greatest inflation hedges is already in their possession. I'm talking about houses and condos. Sure, we saw neck-snapping plunges in home prices over the past five years, though that was partially a function of surging home prices in prior years. Over the long haul, home prices tend to track inflation. That's because the cost to build a new home or repair an existing one always rises as the costs of lumber, siding, plumbing, labor and other inputs rise.
In the early 1970s, a period of high inflation, my parents bought a home for less than $80,000. A decade later, they sold that same home for $225,000. They weren't savvy real estate speculators, just the beneficiaries of high inflation that boosted their home's price by a significant amount.
So there are ways to hedge against inflation. It's just a matter of knowing where to look.
The Investing Answer: Few investors are thinking about inflation right now, but that doesn't mean we'll have low inflation and low interest rates for a long time into the future. Indeed, prices may start to rise as soon as the global economy picks up, perhaps in a year or two. At that point, any slack in the global economy will have been eliminated, creating bottlenecks in shipping and production -- which is often a key precursor to higher inflation. That makes this a good time to start reading up on the kinds of investments that will help protect you against the corrosive effects of inflation.
