Tips For Trading Inflation

By: Wayne Duggan

Rising interest rates and an economy near full capacity means that higher inflation could be just around the corner for U.S. investors (or at the very least, closer on the horizon than traders have been used to). It’s been quite a while since Wall Street has had to deal with the effects of inflation. Here’s a quick reminder of how to play them.

Why Does Inflation Matter?

In a vacuum, inflation is bad news for investors implementing conservative investment strategies because it erodes purchasing power. In a zero-inflation environment, the worst-case scenario for an investor sitting on 100 percent cash assets is that they will generate a zero percent return on those holdings.

However, once inflation is introduced and begins to rise it instantly eats away at the purchasing power of that cash. This effectively creates a situation wherein that investor must achieve a minimum return just to maintain the same purchasing power.

Inflation has also typically hurt stock and bond returns. Although companies tend to earn higher profits during periods of inflation, investors also discount those profits more.

U.S. stocks have generated annualized returns of just 1 percent since the 1930’s during periods in which inflation rose for at least six months. In those same periods, 10-year Treasury bonds averaged a 0.4 percent annual gain.

In non-inflationary periods, historically stocks have generated an overall annual gain of about 7 percent and 10-year Treasury bonds have averaged a 2 percent gain.

The correlation between stocks and bonds also tends to be higher during periods of inflation, increasing the need for investors to diversify into non-traditional assets. Here are three popular ones.

1. Real Estate

Real estate investment trusts tend to perform relatively well during periods of inflation because the properties they own can generate income to keep pace with inflation by raising rent rates for tenants. Like the other examples below, real estate is a popular hedge against inflation because it’s a physical good with a limited supply.

In terms of assets under management, the Vanguard Real Estate Index Fund (VNQ), Schwab US REIT ETF (SCHH), and iShares U.S. Real Estate ETF (IYR) are the three largest ETFs with broad-based exposure to the U.S. real estate market.

2. Gold

Gold has historically been one of the most popular ways for long-term investors to protect against inflation. Most commodity prices tend to rise during inflationary periods, but gold is often a market leader due to its status as a flight-to-safety investment.

The SPDR Gold Trust (GLD), iShares Gold Trust (IAU), and ETFS Physical Swiss Gold Shares (SGOL) are the three largest gold-based ETFs in terms of assets under management, and would all benefit from rising gold prices.

3. Oil

Oil has been a very unpopular investment in recent years after a global supply glut sent prices tumbling from above $100/barrel in mid-2014 to below $30/barrel at one point. Now that expectations for inflation have picked up and OPEC has taken steps to dial back its production, oil prices have recovered to the low $60’s and could gain even more momentum if inflation picks up. The United States Oil Fund (USO), iPath S&P GSCI Crude Oil Index ETN (OIL), and PowerShares DB Oil Fund (DBO) are the three largest non-leveraged Oil ETFs on the market.

Lime Brokerage LLC is not affiliated with these service providers. Data, information, and material (“content”) is provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities. Any investment decisions made by the user through the use of such content is solely based on the users independent analysis taking into consideration your financial circumstances, investment objectives, and risk tolerance. Lime Brokerage LLC does not endorse, offer or recommend any of the services provided by any of the above service providers and any service used to execute any trading strategies are solely based on the independent analysis of the user.

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