Are we seeing the return of inflation? Or deflation?By Kevin Burns
“A well-thought-out family blueprint is an absolute necessity. This includes an asset allocation that offers some protection in all environments.”
WE HAVE A SOLUTION.
The Federal Reserve has just started QE3 (Quantitative Easing Round 3), and thoughtful investors are beginning to fear a return of inflation or perhaps even hyper-inflation. Those of us who lived through the 1970s remember how damaging the inflation of those years could be to a family’s wealth.
The Fed prints money to increase liquidity and drive down interest rates with the goal of reviving a sluggish economy. This action drives down the U.S. dollar and changes the dynamics of our debt, with the Fed being the largest buyer of our debt. The deficit then continues unabated and the national debt continues to explode.
How do we get off this path? History suggests that we will need to inflate our way out of it. Having spent over thirty years in the financial industry, we recognize that we need to consider the flip side and ask ourselves, “What if the inflation hawks are wrong and deflation is in our future? What should an investor do?”
Historically, assets considered a hedge against inflation include hard assets such as real estate, fine art, commodities, master limited partnerships (MLPs), real estate investment trusts (REITs) and stocks. Today, they include treasury inflation-protected securities (TIPS). On the other hand, asset classes that have historically underperformed in inflationary environments include government bonds and other taxable fixed income vehicles.
Many investors have already flocked into inflation hedges (particularly gold), and many of them may already be overvalued and expensive to own. To hedge a portfolio against inflation, investors should consider such factors as the inflation sensitivity, reliability and cost-effectiveness of this hedge. For example, commodity futures and gold have been sensitive to inflation historically but often are not cost effective. However, many “experts” believe we have not even seen the tip of the iceberg with these asset classes. So how can an investor build a portfolio that can grow in either of these environments?
A well-thought-out family blueprint is an absolute necessity. This includes an asset allocation that offers some protection in all environments. For instance, depending on a family’s risk profile and cash flow requirements, a well-balanced portfolio may include:
Investments to protect against inflation:
- TIPS: These offer very low returns, but also a guaranteed hedge against rising prices
- Commodities: In inflationary environments, commodity prices typically rise
- MLPs: Increasing cash distributions based on CPI might make this under-owned, high-income, tax-deferred asset class rise
- REITS: These often own commercial proper- ties and apartment buildings, which in periods of inflation have the ability to increase rents
- Equities: Public companies are often able to pass along rising costs to consumers
Income and deflation protected investments:
- Tax-free municipal bonds: These may be an excellent asset class in a diversified portfolio. We often focus on the short- and inter- mediate-term, highest-rated bonds in this asset class
- High-grade corporate bonds: These offer consistent cash flow and stated maturities
- Alternative investments: These absolute return vehicles have very little correlation to the above asset classes
The key to successful investing remains these three principles that we have followed for decades: diversify asset classes; diversify management style; and rebalance periodically to plan. Our experience has shown that a dynamic, flexible portfolio, rebalanced over time, can succeed in inflationary and deflationary environments.