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Hand drawing increasing inflation rate graph concept with black marker on transparent wipe board … [+]
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Most understand that higher prices reduce the purchasing power of the dollar. This erosion can be mild, moderate, or severe, depending on the level of inflation and other factors. Investing when inflation is rising is of particular importance since the goal is to earn a positive return, after factoring in inflation. This is known as the real return. Where can you invest to beat inflation? What types of investments offer the best opportunity to stay ahead of rising inflation?
Perhaps the most reliable investment designed to outpace inflation are TIPS or Treasury Inflation Protected Securities. TIPS are issued by the U.S. government and carry the same protection against default as other treasury securities. While TIPS are low risk, they are bonds and, like bonds, their performance is affected by changes in interest rates. Let’s look further at how these securities work.
Most bonds carry a fixed rate of interest known as the coupon rate. Thus, if interest rates rise, your bond will still pay the same, albeit lower rate. Because your bond pays less than newly issued bonds (because interest rates have risen), the price of your bond will decline. Investing in a fixed-rate security such as this when interest rates are rising is generally unadvisable.
TIPS are different in that the price of these securities will rise with inflation as measured by the CPI. This boost in price will help to offset the effects of rising interest rates. As long interest rates don’t rise too far too fast, TIPS should produce a positive return after inflation. The ideal time to invest in TIPS is when interest rates are in the upper part of the normal range. Unfortunately, this ideal condition may be rare since rising interest rates tend to follow strong economic growth, which often occurs in the latter phase of the business cycle. Nonetheless, TIPS do offer an attractive choice if the goal is to outpace inflation. However, because they are bonds, don’t expect them to rival stock returns.
Other investments to consider during inflationary times are gold and silver. While neither offers a guarantee against inflation, at times, both do well when prices are rising. Why? It all depends on how investors view these commodities. If the consensus is that gold will rise when inflation rises, then they will buy it, creating strong demand, which will push its price higher. Of course, the reverse can be true as witnessed in the late 1970s and at times during the 1980s when inflation was running hot. It should be mentioned that the price of gold was stagnant from 1980 to 2005, ranging between $400 and $600 an ounce.
Stocks also offer a good inflation hedge but be selective. Since inflation increases the cost of goods, companies must watch their budgets more closely. If costs rise too much, companies will raise prices, leaving consumers to pay the bill. To continue, if prices rise too much, consumers will reduce expenditures to keep their budgets intact. Thus, high inflation can reduce economic growth and ultimately lead to recession. What types of stocks are best? I suggest companies with strong cash flow and good management. For the more cautious, defensive stocks may be a good option.
Will inflation become a problem? That’s hard to say, but as long as demand is stronger than supply – which it is at the moment, inflation will remain a cause for concern. Unfortunately, no one can say exactly how much of a concern.
To read more on the cause of today’s rising inflation, please read my most recent Forbes article, Buckle Up: 3 Reasons Why Inflation Is Rising.
