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| Risk & Reward |
Inflated Expectations
John Ferry
09/01/2005
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After being well at heel for almost a decade, professional and private
investors are seeing worrying signs that inflation could soon slip its leash.
The falling dollar, the fast-rising prices of oil and real estate and an
expanding economy have begun to alarm policymakers at the Federal Reserve—who
have been ratcheting up rates in response—as well as private investors. Indeed,
affluent individuals are now more worried about the effects of inflation than
they are about the performance of the stock market or about taxes, according to
a recent survey by U.S. Trust.
TOP VIEW
Inflation remains low, but a number of factors—the weak dollar, rising oil
prices and the booming housing market, among them—raise concerns that it may
trend upward in the near future. With policymakers unwilling or unable to head
it off, private investors are using a variety of tools, including TIPS (Treasury
Inflation Protected Securities), real return accounts and structured products,
to insulate their portfolios from the threat of renewed inflation. |
The broad inflation figures released earlier
this year supported this anxiety. According to the Labor Department, the CPI
went up by 0.4 percent in February, 0.6 percent in March and 0.5 percent in
April. However, this reversed itself in May, due to a short-term drop in oil
prices; the CPI actually fell 0.1 percent. Yet affluent individuals have cause
to be particularly worried about the effects of inflation on their spending
power in light of the unprecedented increase in the cost of luxury goods (an
index of which rose 11.3 percent from 2003 to 2004, after rising only 6.4
percent the prior year, according to the Merrill Lynch/Capgemini World Wealth
Report 2005).
Inflation can damage a portfolio in two primary ways.
Expectations of future inflation are one of the main drivers of financial market
behavior. If inflation expectations suddenly jump, say, in the wake of a spike
in oil prices, bond prices may plummet. Their link to the markets comes from the
second way inflation hurts investors: It depresses the value of fixed income
instruments, such as bonds and loans, because it makes the cash flows they throw
off less valuable.
Often those who seek to hedge their inflation risk are
advised to simply increase their allocation to equities. The assumption is that
stocks will rise in inflation-adjusted terms because companies are free to raise
the prices of goods and services to keep pace with inflation. Unfortunately,
this is a misconception. “Corporate profits are the difference between the cost
of raw materials and the cost of finished goods, and since inflation typically
originates in the raw materials sector, corporations can’t raise prices until
margins are squeezed down,” explains John Brynjolfsson, real return products
portfolio manager at Pimco, an investment management firm in Newport Beach,
Calif. “That means profits have a hard time doing well in an inflationary
environment.”
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