On Tuesday morning we learned that the Bureau of Labor Statistics’ Consumer Price Index “CPI” rose by the most in over a year in May by 0.3 percent. This comes after last week’s slight announcement that the Producer Price Index “PPI” fell slightly, although keep in mind that consumer prices lag producer prices. Regardless of the slight decline in the PPI last week the overall trend in prices indicates that inflation is starting to pick up, and as investors we need to be ready.
However preparing for inflation is more than simply buying “real assets.” Many investors assume that in an inflationary environment it makes sense to indiscriminately own stocks, commodities, and real estate. But there is a problem with this approach. Stocks typically underperform in the aggregate in an inflationary environment because many companies see rising input costs with inflation that they can’t pass on to consumers without jeopardizing sales.
Furthermore, several commodities are economically sensitive, such as copper. If inflation picks up and the economy weakens as a result the demand for copper will decline, and this will send the price lower, or at the very least it will restrict the ascent of copper prices so that it underperforms inflation. Finally while real estate is a “real asset,” keep in mind that real estate is heavily dependent on interest rates, which rise if people fear inflation because they demand a higher return on their investments.
Given these considerations I have compiled a list of funds that investors should consider for an inflationary environment.
1. Proshares Ultrashort Lehman 20+ Year Treasury Bond ETF (TBT)
If inflation picks up then interest rates will likely rise. This means that bond prices will fall, including Treasury Bonds. Furthermore, long-term debt is more vulnerable to a bear market as longer term bonds carry more risk. So in an inflationary environment investors should consider betting against long term bonds, and the TBT is an excellent way of doing so. This fund trades inversely to long-term Treasury Bonds and it offers 2X leverage. That means if bond prices fall 1 percent the fund rises 2 percent. The patter is reset on a daily basis so this leverage can potentially compound to more than 2X if you get a long string of days where the long term Treasury market falls. But it can backfire—even if bonds trade flat then the fund will slowly lose value. So this is a trading vehicle, which, if used tactfully can generate significant returns over a short period of time.
2. The Powershares DB Agriculture Fund (NYSEARCA:DBA)
People need to eat, and so demand for agricultural commodities can remain robust even while price pressures are rising. This means that agricultural commodities will be among the better performing commodities in the complex. There are various ways for retail investors to gain exposure to agricultural commodities, but if you’re looking for a relatively liquid diversified fund then the DBA is the way to go. Investors with the time and the inclination to research individual commodities should consider looking at the broad selection of individual agricultural commodity ETFs offered by iPath. Some of these include:
- Grains (JJG)
- Sugar (SGG)
- Coffee (JO)
- Cocoa (NIB)
- Livestock (COW)
These funds had a very strong beginning of 2014 but they have largely corrected as of late, which means that there could be some good opportunities.
3. The Market Vectors Agribusiness ETF (NYSEARCA:MOO)
This fund offers investors another way to gain exposure to rising agricultural commodity prices. It invests in companies that service farmers such as seed/pesticide companies (e.g. Monsanto (MON)), fertilizer companies [e.g. Potash (NYSE:POT)] and agricultural equipment companies [e.g. Deere (NYSE:DE)]. Investors should be aware of the fact that these companies could see rising input costs in an inflationary environment, but given that they add value to farmers they can likely pass these costs on to their customers without losing sales.
4. The Sprott Physical Gold ETF (NYSEARCA:PHYS)
Gold should be a strong performer in an inflationary environment because it is a commodity that isn’t economically sensitive. With gold consolidating and with inflation picking up now is a good time to accumulate the yellow metal. The PHYS is one of the better ways to bet on gold. It is a physical gold trust that holds its gold in a vault in Canada. The great thing about this fund is that it is treated like a stock for tax purposes, and so if you hold it for longer than a year your gains are taxed at the capital gains rate. This is opposed to the more popular SPDR Gold Trust (GLD), the gains from which are taxed at the 28 percent collectible rate.
5. The Market Vectors Oil Services ETF (NYSEARCA:OIH)
While the price of oil should perform well in an inflationary environment keep in mind that the cost of producing oil will rise as well, and this will hurt the earnings of oil companies. One way to counteract this in your portfolio is to buy shares in oil service companies, who have relatively fixed costs, but who can also raise their prices with the price of oil. The OIH is a great way to get exposure to the top players in this sector and it should be an outperformer in an inflationary environment.
Disclosure: Ben Kramer-Miller has no position in the funds mentioned in this article.