Inflation strategies[SIZE=-1]Seeking safety during inflationary times We analyzed historical market data to see if it's possible to profit when inflation is rising. Today's investors, though, also have the added complication of recession. We’re not going to sugarcoat it: Inflation is a scourge with no redeeming features. This is evident in our everyday purchases. The numbers on the gas pump move ever faster, and suddenly $2 buys six eggs instead of a dozen.Even worse, the pain doesn?t stop at the gas station and grocery checkout. Inflation nips at the fundamentals of your investment portfolio. No matter how carefully crafted it may be, stocks, bonds, and cash all suffer when inflation is on the rise (though their afflictions differ). For this report, the CR Money Lab examined what an inflationary environment does to each aspect of a portfolio, and looking at the historical data, single out the kinds of investments that are likely to perform best.The big pictureInflation usually puts a crimp on all asset classes, especially interest-bearing investments, such as the following:CashLiquid investments, including money-market funds and bank accounts, and short-term investments like Treasury bills, provide the most obvious example of inflation?s effect. You lose purchasing power over time, and the worse inflation is, the more you lose in real terms. Of course, there has been some inflationary pressure in our economy for more than 50 years. But the difference between a 2 percent annual rate (about the average over the past 10 years) and the nearly 6 percent inflation rate during the 1980s is huge. With 2 percent annual inflation, a dollar is worth only 82 cents after 10 years, which is bad enough. But at 6 percent, that same dollar erodes to 58 cents. In mid-July, as we wrote this, inflation stood near the high end of that range, at 5 percent.Of course, unless you keep your cash in a mattress, it will earn interest that will offset inflation to some extent. However, historical data show that during periods of rising inflation, the real return an investor receives (in other words, the return adjusted for inflation) is still negative. The most recent example of this was in the 1970s, when Treasury bill investors experienced negative real returns from 1973 through 1980.BondsFixed-income investments like bonds are an even worse place for your money to be when inflation is on the march. In general, when inflation rises, prices of existing bonds naturally fall, since the future interest payments the bondholder expects to receive will be less valuable.The past 25 years have been one of the greatest bull markets for bonds. The total return on government bonds beat inflation by more than 5 percent annually from 1977 through 2002. With long-term Treasury yields just under 4 percent, down from a high of 15 percent in the early 1980s, there is little room for further gain, but a lot of room for loss if long-term interest rates rise.StocksSo that leaves stocks, which have been poor performers of late. They recently entered bear territory when the major market indexes slipped 20 percent from their most recent highs of last October. Since 2000, the total return on stocks has been barely 1 percent annually, as measured by the Standard & Poor?s 500, during a period of relatively benign inflation until the recent upturn.But wait, it gets worse: Stocks tend to perform badly during periods when inflation is rising and corporate earnings are declining, which is the unfortunate situation investors are currently facing, as they did in the 1970s (see How major sectors have fared). But that analysis looks at stocks as a whole, and generally large- and mega-cap stocks.Looking for winnersTo find out if there are any diamonds, or even semiprecious stones, out there, the CR Money Lab looked to see which sectors outperformed the rest of the market during periods when inflation was rising?not necessarily soaring, just trending upward. Naturally, each of the four periods we examined was influenced by events of the time. For example, in 1990 prices were rising in the wake of the Iraqi invasion of Kuwait. And in the late 1990s we were beginning to experience the thrill of the tech bubble. During each of those periods, inflation was rising. But the annual rate was still never more than 5.4 percent and usually less than 4 percent.Depending on the period, there were different leaders and laggards. And the performance of some sectors was influenced more by the fundamentals of those industries than by the inflation outlook. For example, health care was growing by leaps and bounds for more than a decade as an aging U.S. population boosted demand for medical care and many new and expensive blockbuster drugs were introduced. The telecommunications industry was jostled by increased competition and too-rapid expansion. And the tech boom, as many of us remember, had become a tech bust by 2000.Some sectors did tend to do better than others in periods of rising inflation (see How sectors fared during inflationary periods). For instance, energy typically outperformed the overall market in those periods, which is not surprising because the sector is largely based on commodities.But consumer staples, like food, beverages, and household products, generally fared poorly. This is worth noting since many investors might be looking to invest in that sector because it?s considered defensive, meaning that it sells products that consumers will continue to buy in bad times as well as good ones. However, companies in this sector might also be hindered by inflation as they struggle over whether to absorb cost increases or raise prices, both of which contribute to a smaller profit margin. So although they might be the place to be during a recession, they might not be the best bet if we?re coping with both recession and inflation?the dreaded stagflation.Hedges that might helpThere?s no question that these are challenging times for investors. If inflation gets worse than we?re currently experiencing, it?s going to be difficult to overcome the double whammy of rising prices and declining stock values.One possible remedy is to include a small investment in commodities in your portfolio. Commodities, as we?ve pointed out in the past, don?t correlate with movements of stocks or bonds. Moreover, they tend to do handsomely when inflation gets out of hand, and it may take only a small amount of them to make up for investments that are facing inflationary headwinds. For instance, a portfolio made up of 60 percent stocks and 40 percent bonds would have lost 6.3 percent in the first half of 2008. But shifting just 5 percent of the portfolio to commodities would have meant a loss of only 4.7 percent.Would investing outside the U.S. blunt inflation?s impact? It depends on where you invest. As uncomfortable as inflation is here, its sting is far more acute in many developing nations. Morgan Stanley estimates that a quarter of the world?s economies currently have inflation rates greater than 10 percent. In Russia, the rate of inflation is now 15 percent, and in smaller emerging economies such as Vietnam, it?s even higher.In many emerging markets around the world, food?a commodity that is rising in price even faster than oil?eats up a greater share of household income than in developed markets. That makes coping with inflation in those economies very difficult, which adds to the already considerable risk of investing in emerging markets. If their central banks continue to try to keep a lid on inflation by raising interest rates, as many have done in the past two months, the local economies will slow down, which isn?t good news for stocks. But neither is high inflation, which also erodes the value of stocks. If you?re looking for some emerging-market exposure in your portfolio, consider regions rich in commodities, such as Russia and Latin America.[/SIZE] [SIZE=-1]Subscribe now![/SIZE]
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