Inflationary Fire Insurance

Inflation now looks a near-certainty. The only unknown is its timing...

THE FLAMING EMBERS of inflation have already landed atop the thatched roof of American finance, writes Eric Fry in the Rude Awakening.

And yet investors can still buy fire insurance on the cheap.

In the next 1,373 words, we'll examine a few of these "inflation insurance policies" to assess their virtues and drawbacks. Because a powerful new inflationary trend is very likely to occur, and the prudent investor should probably take steps to guard against it.

"But wait a second!" some readers may say. "What if a powerful deflationary trend occurs first?"

Good question. Because it might. But we'd begin preparing for inflation anyway. Its arrival is near-certain. The only real uncertainty is its timing. Imagine an infallible clairvoyant told you that your house would burn down in one of the next five years, would you say to yourself, "Gosh, maybe I should try to figure out which year it will be and not buy fire insurance during the other four years."

You might actually guess correctly, in which case you would have saved yourself four years worth of insurance premiums. But you might guess incorrectly, in which case you would have lost your house.

Your call.

To this market observer, inflation seems like a near-certainty. Not an absolute certainty, mind, you, just a near-certainty, sometime within the next three years. So why not beat the rush to buy inflation insurance? Why not buy some now?

The nearby chart displays a sampling of inflation hedges, and how they performed during the last eight years of the infamous 1970s. Gold was clearly the standout winner. But we'd put an asterisk next to this result, due to a performance-enhancing assist from the US government.

You see, during most of the preceding four decades, the US government had been artificially suppressing the Gold Price at $35 an ounce, while also forbidding private US citizens from owning it. Therefore, once the government removed it cap – and removed the exchange controls on owning Gold Bullion – the price partied like a teenager whose parents had just left town.

Aside from Gold Investing, very few assets managed to keep pace with inflation as measured by the Consumer Price Index (CPI).

Hard assets like the CRB index of commodity prices and the Swiss Franc did outpace the CPI, but stocks and bonds both lagged miserably.

Skipping ahead about 30 years, we can see that the modern versions of the 1970s inflation hedges have performed quite poorly during the last 14 months. Clearly, inflation is not a widespread concern. But that's part of the reason it concerns us, and also part of the reason why we'd be inclined to take action now, while inflation hedges remain relatively cheap.

Our contrarian instincts lead us – rightly or wrongly – to distrust the consensus, especially when the consensus trusts in an idea like deflation. We don't think deflation is stupid, just unlikely. More precisely, we suspect that deflationary indicia will be seasonal, like daffodils.

For a while, they will seem to be everywhere. Then, just as suddenly, you won't be able to find a single one.

So with that biased and unscientific preface, let's sweep through a Reader's Digest review of ETFs that might provide some kind of hedge against inflation:

Gold: The "Old Faithful" of hedges. It's always worked before. Enough said. Exchange-traded funds like the SPDR Gold Trust (GLD) provide easy access, but without any actual ownership. With a $30 billion market capitalization, the "Spider" is now the go-to Gold ETF for big institutions. The next largest entrant is the iShares Comex Gold Trust (IAU) with a market cap of $2 billion. Both ETFs enable an investor to buy gold with a mouse-click. No muss. No fuss. But purists may wish to buy bullion coins like Krugerrands or Maple Leafs. As a gold investment, bullion coins have the advantage of being shiny, pretty and portable. But they have the disadvantage of costing 6% to 10% more than bullion itself, while also being so shiny and pretty that someone might want to steal them. [Ed.Note: Investors looking to square the circle, taking ownership but slashing their costs, might want to consider BullionVault...]
Gold Stocks: The bastard brood of gold and the stock market. As inflation hedges, Gold Mining stocks can be somewhat unpredictable and capricious. Over a multi-year span of time, they tend to reflect the gold side of their heredity. But during shorter time spans, gold stocks can behave much more like stocks than like gold...and that's not always a good thing. That said, ETFs like the Market Vectors Gold Miners (GDX) provides a handy way to buy a basket of gold stocks.
Commodities: Like gold, a basket of commodities that includes crude oil, copper and wheat tends to provide a very reliable hedge against inflation. Unlike gold, a basket of commodities provides diversification across multiple assets and – therefore – much lower volatility than gold alone. The largest commodity ETFs available are the PowerShares DB Commodity Index Tracking Fund (DBC) and the iShares S&P GSCI Commodity-Indexed Trust (GSG). DBC holds only six commodities: Crude oil, heating oil, aluminum, corn, wheat and gold. GSC holds a much broader collection of commodities.
Commodity-Focused Stocks: See comments on #2 above. The iShares S&P North American Natural Resources Sector Index Fund (IGE) provides broad exposure to commodity-focused stocks. Alternatively, the DWS Global Commodities Stock Fund (GCS) is a small closed-end fund that holds a similar portfolio. But GCS is selling 12% below its net asset value, which means that a buyer at the current quote controls one dollar worth of resource stocks for only 88 cents.
Non-Dollar Bonds: The Swiss Franc performed quite admirably during the last Great Inflation in the United States. But we are hesitant to bet on a repeat performance. Indeed we are hesitant to bet on ANY foreign currency as a way to hedge against US inflation. The Swiss economy, for example, no longer features a bunch of pocket-watch-toting gnomes doing nothing but guard vaults full of Gold Bullion. Instead, the modern Swiss economy also features pocket-watch-toting gnomes masquerading as hedge fund managers. The predictable result is that Switzerland's two largest banks have amassed questionable derivatives exposures that exceed the GDP of the entire country. Many other bankers speaking many other languages have achieved equally enormous feats of stupidity. No one knows how these feats of stupidity will influence the values of their native currencies. Not knowing, therefore, we are disinclined to guess. But those readers who suspect that the Dollar will be one of the first currencies to go down in flames, rather than one of the last, might be interested in the one of the many ETFs that hold foreign currencies. The CurrencyShares Swiss Franc Trust (FXF), for example, holds Swiss francs. Alternatively, the Dollar-phobic investor could purchase the SPDR Barclays Capital International Treasury Bond ETF (BWX) that holds a basket of bonds issued by foreign governments. Its largest allocations include a 23% weighting in Japanese government bonds, 12% in Germany and 12% in Italy.
TIPS: No discussion of inflation insurance would be complete without mentioning TIPS, short for Treasury Inflation-Protected Securities. Investors may purchase a basket of TIPS by buying the iShares Barclays US Treasury Inflation Protected Securities Fund (TIP). In theory, TIPS provide a direct and reliable hedge against inflation. But like so many other seemingly brilliant ideas, TIPS work better in theory than in practice.
The first risk to a TIP is an overt one: Deflation might persist for longer than expected (by us). In which case, the principal value of a TIP could decline below par. And even though the holder of the TIP would receive par at maturity, the interest payments that the holder would receive between now and maturity would decline in concert with the declining principal value.

The second risk is a covert one: The federal government controls the calculation of the Consumer Price Index (CPI). Therefore, if the CPI, as currently constructed, were to get out of hand and produce very high inflation readings, the government's bean counters would probably spring into action to create a "new and improved" CPI that would deliver much lower inflation readings. It has happened before. We all know it could happen again.

Thus concludes our review of inflation hedges. We hope all readers will utilize the delightful deflationary interlude we are now enjoying to prepare for what may lie ahead. Hostile inflationary forces may be amassing their forces at the borders of our economy at this very moment.

In short, we think it's a good time to risk being paranoid about the threat of inflation.