For the last two decades, Americans have enjoyed one of the most benign inflationary environments in the country’s history (as measured by the Consumer Price Index, or “CPI”), a far cry from the late 1970s when inflation peaked at more than 16 percent and 10 percent year-over-year jumps in the CPI were becoming routine.
Since then, the Federal Reserve has sought to keep inflation in check by carefully monitoring interest rates and the money supply. The result has been an average annual increase in the CPI of 2.50 percent for the past 20 years (i.e. the compounded annual growth rate from Dec. 31, 1990 to Dec. 31, 2010), leaving inflation essentially “out of sight and out of mind.” And inflation was pushed even further down the list of concerns at the start of the financial crisis as everyone’s attention instead turned to the very real question of whether the global economic system was about to disintegrate, creating worldwide deflation.
We’ve obviously taken several steps back from the brink since the dark days immediately following the collapse of Lehman Brothers. But regardless of where one stands with regards to the efficacy of the government policies that were put in place to stimulate the economy, history tells us that large-scale monetary infusions are often followed by periods of rising inflation.
Inflation is already becoming an issue in a number of emerging markets, with China, India, and Brazil responding by increasing interest rates. While the picture in the U.S. has been relatively benign, there is a growing school of thought that it is only a matter of time before inflation lands on our shores, too. When and if that happens, the impact on investors’ portfolios could be severe.
Take, for example, an individual who had $1 million in cash in 1969. Over the next 40 years, which included periods of both high and low inflation, the purchasing power of that money would have declined by more than 82 percent. Obviously, cash is not king when it comes to battling inflation.
Treasury Inflation-Protected Securities (“TIPS”) were introduced in 1997 and quickly became a widely favored method to hedge against inflation. But over time, it’s become clear that TIPS are actually more closely correlated to the movements of the general bond markets than to the ebbs and flows of inflation. Hard assets, particularly gold, have also proven to be a popular defensive vehicle, but the volatility inherent in most commodity holdings can also make them inadequate as for fighting inflation.
Essentially, those looking for that one answer to help fight inflation are instead coming to the conclusion that there is no one answer. Single-asset inflation hedges all face structural limitations on a variety of fronts, including duration risk (in the case of fixed income holdings), volatility, correlation issues, taxation concerns, or some mix of all of these factors.
Fortunately, new options are emerging for investors. Recent research has shown that a multi-asset approach, which includes exposure to equities, commodities, currencies, short-term fixed income, and real estate, offers a highly effective way to hedge against the impact of a rising inflation. The relative allocations to these asset classes can be adjusted over time, to reflect changes to the inflationary environment.
This, of course, is a more complex strategy than simply buying and holding TIPS. Some advisors may be comfortable in building their own multi-asset class portfolios. But for those who want a ready-made solution, new Exchange-Traded Funds and other products have emerged to provide a simple way to allocate a portion of a client’s assets to an inflation fighting vehicle.
The past few years have provided a stark illustration of the ability of markets to surprise on both the upside and the down. It may be that inflation is the next big economic challenge to make an unwelcome return. The limitations of the most popular inflation fighting vehicles are becoming too pronounced, and the risks from inflation are too real, for the status quo to continue to reign in portfolio construction.
Adam Patti is the CEO of IndexIQ, which sponsors a number of Exchange-Traded Fund offerings, including IQ Real Return ETF (NYSE Arca: CPI), the first inflation-hedged ETF listed in the United States.
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