Does it feel like the dollar in your pocket today buys less than it did a year ago? You’re not alone. The latest U.S. inflation data confirms that the prices of goods and services are rising. Why is inflation headed up, and what are the consequences for investors?
It’s official: inflation is back. The consumer price index hit 2.1% at the end of 2016 — the highest level since June 2014. For investors, an upturn in inflation can be a big deal. With that in mind, here are three facts investors need to know.
1. The Scene Is Set for Higher Inflation.
The latest inflation figure may have grabbed the headlines, but evidence suggesting higher inflation is coming has been around for a while. Longer term U.S. Treasury yields are often a good barometer, and they first started to move up in mid-2016.
Factors lifting inflation include prospects for greater government spending under the new administration, higher housing prices and increased fuel costs. Oil prices have recently been above $50 a barrel, about double the level of around a year ago when they hit a 13-year low of $26.
Wages are another important factor to keep an eye on. Given that the unemployment rate (4.7% in December 2016) is close to the Federal Reserve’s estimate of full employment, pay increases could become a key source of inflationary pressure.
2. Inflation Can no Longer Be Ignored — Especially if You Rely on Investment Income.
Inflation has hardly been a top concern for most investors lately, but that should change in 2017. Preserving purchasing power is particularly important to investors who are in or close to retirement.
When drawing retirement income to cover everyday expenses, you want to ensure that you are able to do so in a sustainable way that reflects rising costs for things like food and gas.
Of course, how much dedicated inflation protection investors in or near retirement need will vary with their particular financial circumstances. Tolerance for risk is another important consideration.
3. One Simple Idea for Investors Seeking to Preserve Purchasing Power.
My focus here is on bonds, though it’s important to acknowledge there are parts of the stock market that have fared well in some past episodes of rising inflation, such as stocks in the health care sector.
By the same token, it should also be remembered that no two periods of inflation are the same. Inflationary factors can combine in a variety of ways that have quite different outcomes for stock returns. For instance, financial stocks did relatively well in the period 1999 to 2001, when the unemployment rate fell below 4% and oil prices surged. On the other hand, between 1978 and 1980, oil prices also skyrocketed, while unemployment was mostly in the 6%–7% range and financials lagged.
When it comes to bonds, however, there’s good reason to believe that including Treasury Inflation-Protected Securities (TIPS) in an investment mix can be helpful. TIPS are bonds backed by the full faith and credit of the United States government. Unlike standard Treasuries, the value of TIPS generally moves up with rising inflation. Importantly, if there’s negative inflation (known as deflation) over the life of a TIPS bond, the investor is guaranteed to receive the initial amount paid for the bond.
Depending on an investor’s objectives, investing in an actively managed inflation-linked bond fund could be a sensible option. All in all, TIPS appear to offer good value — even after a 4.7% rally in 2016. Break-even inflation rates — the average inflation required over the life of a bond for TIPS and nominal Treasuries to generate the same total return — have moved higher in recent months. Importantly, however, there seems to be some potential for actual and expected inflation to surprise on the upside and boost returns for TIPS.