How Inflation Affects Your Investments

Investors should review their holdings and prepare to protect market returns from erosion.

Inflation has not been a serious issue for investors for several years, given ultra-loose monetary policy by the Federal Reserve, stagnant wage growth and falling commodity prices.

But there are signs that inflation may be returning. The annual consumer price index for March rose 2.2 percent following February's 2.3 percent rise. After falling for nearly two years, crude oil prices may be bottoming and wage growth is starting to pick up.

No one expects the runaway inflation of the 1970s and 1980s, so there's no need to unearth the Gerald Ford-era "Whip Inflation Now" lapel buttons. Still, market watchers say, investors should review their holdings to prepare for possibly rising prices.

"Inflation is going to erode your returns across your portfolio. It depends on the asset class. Some perform better in an inflationary environment," says Adam Patti, chief executive officer of New York-based IndexIQ.

Signs of the times. Chung Wang, senior analyst and co-portfolio manager for several investment funds at Minneapolis-based Leuthold Group, says higher crude oil prices, a weakening dollar and a rising Chinese yuan are three market-based forces that portendhigher inflation. More significant signs of inflation, like a pickup in wage growth, add to the idea of rising prices.

"One can argue we're on the cusp of a breakout in inflation," Wang says.

However, he says other factors like the velocity of money – how quickly funds move through the system – and capital utilization rates aren't following through, which makes him more conservative in his inflation outlook.

Others say higher prices for services like health care and rents are signs inflation may be under way. "I think inflation has been here, it's just not in the headline number," Patti says.

Willie Delwiche, Milwaukee-based investment strategist at Baird, says historically the sectors most hit by rising inflation are bonds and bond-like equities such as utilities and telecommunications. In 2016, utilities and telecoms have outperformed other asset classes, so if inflation picks up, investors with higher exposure may want to reconsider the role those sectors play in their portfolios.

A complex interaction. The relationship between stocks and inflation is a little more complicated than it is for bonds, Wang says, with a moderate amount of inflation the best for equities.

"Right now we're on the low end of the historical inflation zone. An uptick would be good for stocks," he says.

Delwiche says while everyone's portfolio is different, from a general perspective investors should look to areas of more growth, such as industrials and information technology.

Dan Heckman, national investment consultant for U.S. Bank Wealth Management in Kansas City, Missouri, says if investors are underweight in materials or oil-related stocks, now might be time to consider those sectors. Heckman cites Chevron Corp. (ticker: CVX) as an example.

"Some of the oil stocks have been forecasting a bottoming process here," he says. "Look at Chevron. It had a low of $69 in the last 52 weeks and now it's trading at $97. It's still under $112, which was the 52-week high, but it's reflecting oil has bottomed at a minimum. If you've been under invested in those areas you can look to sell off to add to exposure."

Is it time for TIPS? Many investors consider Treasury Inflation-Protected Securities, known as TIPS, as automatic investments in times of higher inflation. But Heckman and Patti say investors need to understand these products.

TIPS are geared to movements in the CPI, not necessarily because rates are rising, Heckman says. There can be some tax issues if TIPS are owned outright, but that's less of an issue if TIPS are in a mutual fund, he says.

Patti says if investors buy a fund, they should also be wary of duration risk – that is having securities that don't mature for several years.

"If you buy TIPS bonds when issued and hold them to maturity, you're fine; that's what they're designed to do. But if you buy in a laddered portfolio, it introduces duration risk," he says.

There are other options. Heckman says floating rate securities may be a better choice in some cases. High-yield bonds can work in rising inflationary environments, but Michael McClain, portfolio manager of Hedeker Wealth at HedekerWealth.com, offers some caution.

"Generally, increasing inflationary cycles are positive for risk and spreads. However, you want to be careful chasing yield at this point in the credit cycle. As we move into the next phase security selection will be paramount. Make sure to do your homework," he says.

Many investors may consider gold as an inflation hedge. The yellow metal's price is up about 18 percent so far this year, but not because of inflation. Instead, the gains are pushed by concerns about loose monetary policy from the European Central Bank and the Bank of Japan leading to negative interest rates.

Heckman calls gold an "imperfect hedge" against inflation. "We think gold is a better hedge against currency volatility or depreciation," he says.

Plus, McClain says, gold's gains this year make it no bargain. "Given the run up in gold as a safe haven, other precious metals such as silver or palladium may provide a more attractive entry point," he says.

Delwiche says while inflation may be returning eventually, it is important investors not get too nervous.

"I think inflation is going normalize. But I think that's going to be a shock to people; the first whiff, it's going to feel like inflation is getting out of control," he says. "But not really. Maybe we go from 1.5 percent to 2.5 percent in terms of inflation. It's not looking at 4-5-6 percent inflation, which in inflation scares in the past you've seen those emerge."

Source: "Debbie Carlson, US News & World Report"

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