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.
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.
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.
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.
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.
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