One of the major concerns for investors in the current economic environment is the potential for significant future inflation. As financial advisers, we probably receive more questions on this topic than on any other pressing financial issue in the news today. It is no surprise that investors are worried about the prospects of severe near-term and long-term inflation, considering the recent steps taken by the federal government and the Federal Reserve in the fight against a slowing economy.
The Federal Reserve cut short-term interest rates to a historically low level of nearly zero in December 2008, and has since held them steady. The Federal government has committed to spending trillions of dollars within the framework of the broad economic stimulus package. The U.S. Treasury has been printing money at an unprecedented pace, while the Federal Reserve has begun purchasing Treasury bonds.
All of these actions are inflationary and, if left in place too long, could lead to above average inflation or, quite possibly, hyperinflation. The federal government, Federal Reserve, and Treasury are faced with the difficulty of weighing the near-term economic risks against the potential for runaway inflation.
Investors, on the other hand, are faced with the challenge of maintaining investment portfolios that can withstand the current economic challenges, while providing a hedge against future inflation. Investors must pay particular attention to the type of equity and fixed-income investments they currently hold in an effort to mitigate the impact of potential soaring inflation.
Stocks are usually a good hedge against inflation because the revenue and earnings of companies should, at a minimum, grow at the same rate as inflation over time. However, if inflation is running too high, companies in certain sectors may be unable to pass along the entirety of increased costs to consumers. Market sectors that historically handle inflation well are consumer staples and energy. On the contrary, consumer discretionary and technology companies typically struggle when dealing with the effects of high inflation.
Fixed income investments, as a whole, are negatively impacted by inflation. However, one type of fixed income security that has some protection against inflation is the Treasury Inflation Protected Security (TIPS). TIPS are similar to other Treasury bonds, except that the interest payments and underlying principal are automatically increased by the equivalent increase in the Consumer Price Index (CPI), the leading measure of inflation. The downside to TIPS is that they pay a lower rate of return than Treasury bonds. Aside from utilizing TIPS, an effective way to minimize the impact of future inflation on a fixed-income portfolio is to invest in short-term fixed-income securities. A portfolio comprised primarily of fixed-income securities with maturities of five years or less will reduce the impact of being locked into a low rate, while general market rates are rising.
For more information on how to protect your portfolio against the prospects of significant inflation, contact Henssler Financial at 770-429-9166 or at [email protected]