Worried About Inflation?

August 26, 2009 - 10:46 AM

Increasing concern about inflation has prompted investors to ask questions about at least two “inflation hedges”: Gold and TIPS (Treasury Inflation Protected Securities).  While there are plenty of things that could be said about both, here a couple of caveats that have caused us to not include these in our client portfolios.

 

Recent history for gold as an inflation hedge is less than conclusive. 

 

“In the five highest inflation years since World War II – 1946, 1974, 1975, 1979 and 1980 – the average real return on stocks, as measured by the Dow, was minus 12.33 percent compared to 130.4 percent for gold, according to metals dealer Blanchard & Co.  But there are problems with relying on gold alone as a hedge to inflation.  Specifically from 1980 to 2001, prices in general doubled, but gold’s price fell from $850 to $257.”  Research Magazine, July 2009, Inflation Proofing

 

Investors thinking about gold as a hedge or alternative to equity markets need to look carefully at gold’s price history.  As the article mentions, gold’s price in 1980 (29 years ago) was $850 / ounce.  Gold was trading in the mid $800’s as recently as December 2008 representing a 0% return over 29 years, before inflation.  That would have been an expensive “hedge” compared to stock and bond returns over the same period.  To capture positive return from gold, investors must be able to buy and sell at the right time.  Historically, the ability for any investor to consistently do this has proven to be very, very difficult.   

 

Compared to gold, using TIPS as a long-term hedge against inflation should prove to be far more effective if investors can buy and hold them to maturity.  TIPS are government bonds whose principal value is adjusted monthly based on changes in the CPI-U.  Future coupon payments are based on this adjusted principal value.  At maturity, the inflation adjusted par value is repaid to the investor. If the period has been deflationary, the principal value repaid would not fall below the original par value. 

 

But this inflation hedging comes at a price.  TIPS are relatively long-term bonds, making them subject to price volatility as interest rates change.  For example, the market price for TIPS fluctuated between 89.3 and 135 in 2008 (Wealth Manager, July/August 2009, “Riskier Than You Think”.)  This price volatility means that an investment in TIPS should be considered a long-term holding since short-term liquidity cannot be counted on.  Also, TIPS generate taxable income on both the coupon payment and the increase in principal value each month.  This increase in principal value is a type of “phantom income”, causing an increase in taxable income with no increase in current cash flow to the investor.  As a result, TIPS are best held in a tax-sheltered account.

 

Foster Group continues to believe that short-term, high quality bonds provide stability and liquidity in the portfolio versus longer-term bonds which may add unwanted volatility.  In today’s very low interest rate environment, rates seem more likely to rise than fall in the near- or intermediate-term, putting downward pressure on the price of long-term bonds, whether they are inflation-protected or not.  TIPS represent an interesting inflation hedge, but they may not be able to provide the short-term liquidity and stability many investors want in times of economic and market uncertainty.

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Foster Group is a fee-only financial planning and investment advisory firm, dedicated to providing objective, unbiased advice to clients. Founded in 1989, Foster Group has always been committed to having each client experience true personal wealth through sound, disciplined financial strategies integrated with individual, family, and organizational goals.

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