Time To Consider Some Inflation Insurance?

As I have written before, I firmly the believe that the actions being taken by the U.S. Federal Reserve and most other major central banks around the world, while costly and politically unpopular in many circles, are both necessary and correct. We are in the midst of a major global recession caused by an intense deleveraging movement by businesses and consumers. Financial markets have experienced a massive flight to quality. There are very few historical parallels to this situation, but history clearly indicates that to keep the current situation from deteriorating into a prolonged and deeper recession and potentially a deflationary spiral, central banks need to act as a counterweight to the deterioration in both credit and liquidity by re-inflating the financial system. Here in the U.S. the Fed is literally throwing everything, including the proverbial “kitchen sink”, into the effort to repair the system and restore economic stability.

My biggest concern is not that the Fed’s action will not work; they will eventually produce the desired results, but rather the consequences and future cost of the “fix”. One of my bigger concerns is future inflation. You may ask how I can be concerned with inflation when the global economy appears to be walking a very thin line between disinflation and deflation. Providing liquidity basically means printing money. This action has the potential to be extremely inflationary. In the short run it is not, because it counterbalances a decrease in the money supply due to the aforementioned deleveraging and flight to quality. Eventually, however, the effect of all that liquidity will produce the desired result (people start spending again) and then the Fed must withdrawal liquidity to avoid inflation (too much money chasing too few goods and services). There are two problems with this. First, central banks tend to err on the side of caution, meaning rather than nip off a developing recovery the Fed will keep then excess liquidity out there longer. The second is that politically, it is more difficult to withdraw liquidity and rain on the recovery party.

My working hypothesis is that liquidity actions by global central banks begin to take hold late in 2009 and the recession bottoms during that time. Inflation then, may rear its ugly head by mid to late 2010. I believe it is prudent to begin to seek opportunities to reposition some assets as “inflation insurance”. Assets that I am considering include real estate, commodities, infrastructure investments and Treasury Inflation Protected Securities (TIPS).

Right now TIPS appear to offer a decent entry point. For a discussion of what TIPS are and how they work to protect your spending power, please see my article on TIPS recently posted on Pilot Capital’s website http://www.pilotcapitalmanagement.com/files/TIPS%20Article%201-9-09.pdf. As of this writing, The Vanguard Inflation Protected Securities Fund (VIPSX) offers a yield of 3.02% without any inflation adjustments. The comparable treasury fund, Vanguard’s Intermediate Term Treasury Fund (VFITX) yields 2.02%. TIPS are commonly valued in terms of the Break Even Inflation Rate (BIR). Normally the BIR would be on the order of 3%, in other words inflation would have to be at least 3% to have the TIPS perform equal to the comparable treasury. Right now the BIR is -1%. This means that the market is expecting consumer prices to drop 1% a year for the next 7-10 years. I view this as possible, but not probable as, since 1933, there have been only three years when the CPI growth rate was negative. The way I look at it, we can buy a U.S. Treasury bond with absolute inflation protection for 1% more yield than one with no inflation protection. In other words the U.S Treasury is buying our inflation insurance. Sounds like a deal!

A couple of caveats however, are in order. Note that TIPS work much better in tax advantaged portfolios such as IRA’s as the inflation adjustments to TIPs represent a taxable event and lower the after tax return in taxable accounts. Interestingly, this is an asset where the ETF alternative is not cheaper. Both the IShares Barclays TIPS Fund (TIP) and VIPSX charge an identical 0.25%. In addition, there is currently a disconnect between the net asset value (NAV) of the ETF, and its actual price. The ask premium over the NAV at the date of this writing is about 3.5%. Paying this premium would more than negate the advantage over the comparable treasury. Even with the trading advantages of the ETF, I prefer the mutual fund in this case.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investor’s should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.