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Digg| On the Economy Expert Roundtable on Inflation: Should You Be Worried?Mark W. RiepeCFA, Senior Vice President, Schwab Center for Financial Research Liz Ann Sonders Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc. Rob Williams Director of Income Planning, Schwab Center for Financial Research Michael Iachini CFA, CFP®, Director, Investment Manager Research, Charles Schwab Investment Advisory Brad Sorensen CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research April 1, 2011 Inflation is a rise in the general level of prices of goods and services; your money buys less. With oil and other commodity prices rising, the Federal Reserve's current easy monetary policy and the economy picking up, many investors are worried about inflation. Mark Riepe, head of the Schwab Center for Financial Research and president of Charles Schwab Investment Advisory, Inc., led a roundtable discussing why Wall Street and Main Street may have different perspectives on inflation now. The roundtable also covers our inflation outlook, ways to protect your investments and inflation-savvy investments you might want to consider. Mark Riepe: The Fed has pumped a lot of money into the economy and the economy is picking up some steam. We also have ongoing Middle East turmoil resulting in rising oil prices. On the surface, it seems to be a perfect environment for rising inflation. What's your outlook on inflation during the next year or so? Liz Ann Sonders: Yes, the Fed has pumped a tremendous amount of money into the banking system. It does look like a ripe environment for what we can think of as generalized inflation, often called core inflation, where prices rise across the board. However, there are some unique things happening right now that suggest the near-term risk of core inflation remains relatively low. The key issue is that money currently resides in the banking system as reserves and, to a large degree, is being used by the banks to rebuild their reserve base and their profitability. It's only when that money is lent out more vigorously that inflation starts to become a risk. One of the primary ways to measure that, in addition to just looking at general lending statistics, is to look at something called the velocity of money, or the money multiplier, which takes M2 money supply and divides it by the monetary base. What that measures is whether money that's sitting in the banking system is coming out via lending and going into the economy and multiplying as it typically does. For example, somebody goes and borrows money from a bank. They take that money and ostensibly do something with it—buy something, invest in something, build something—the recipient of that money now has that money, and so on: It multiplies. We've seen a huge surge in the monetary base because of all this liquidity, but the money multiplier is still basically on the floor. It's actually been declining, not increasing. So even though lending is picking up a little bit right now, the amount of liquidity the Fed is pumping into the system is greater than that, such that the overall measure of velocity keeps going down. There's almost no history in either developed or emerging economies of getting a core inflation problem with no velocity of money. Eventually, we need to see velocity pick up; otherwise, you don't get anything resembling a decent expansion in the economy. But it's only at the point it begins to accelerate that core inflation risk rises meaningfully. But that's only one of several reasons why generalized inflation risk is limited right now. MR: Some say you can't have a general increase in inflation unless you've got inflation in wages. What do you think about that? LAS: I absolutely agree. Without rising wages, you can't typically have higher aggregate or core inflation. You can think of that somewhat anecdotally, but you can also look at a mathematical correlation between a variety of factors and core inflation. In terms of the wage-type pieces, whether it's wages as measured by average hourly earnings or the cost of labor as measured by unit labor costs, any of those employment-related or labor wage-related components have a very high correlation to the core Consumer Price Index. In other words, more than 70% of the time, changes in wages and unit labor cost directly impact changes in core inflation.1 If you were to look at what's happening with wages right now, the pressure has actually been down quite a bit. The same with unit labor costs—very low and mostly downward pressure until very recently. This is in stark contrast to what was experienced in the 1970s and early 1980s. What we're presently experiencing is rising commodity prices. For producers of those commodities, that's been a good thing—they're getting higher prices. As products move from the raw materials stage to items people ultimately buy in the store, labor costs in modern times have been making up a larger component of the total cost structure. And labor expenses have been tame, meaning that higher input costs are essentially being diluted by lower labor costs and wages, as products move through the whole chain from being extracted, all the way to the store shelves. You basically have wages absorbing the higher costs, and that's why you haven't seen margin pressure and that's why you haven't seen inflation erupt in a more generalized way. There's so much slack still in the labor force that labor is basically bearing the brunt of this with lower wages, such that the costs don't get passed on to the end consumer. Put another way, higher commodity prices are acting as a regressive tax on the US consumer. That situation won't last in perpetuity. If we get improvement in job growth, as we think we will, that will put some upward pressure on labor costs and wages, which could start to allow more of those rising costs at the producer end to be passed through to consumers. But until that happens, there's little risk of rapidly rising core inflation. MR: It sounds like for the next year or so, you see very little risk of core inflation unless we see changes in some of those factors you just identified. LAS: Exactly. I would call those factors the proof statements for limited or benign core inflation risk now, but I would also cite those factors as the checklist for what to keep an eye on to get a sense of when core inflation risk is starting to increase. MR: I hear a lot of people say things like, "Given the size of the federal debt, velocity of money can't stay on the floor, to use your term, forever—that we have to expect high rates of inflation going out over the long term." This would be really important to a bond investor, or anyone living on a fixed income. What are your thoughts about the long term? LAS: I think nothing is guaranteed. You could certainly make the argument that we're stacking up some of the conditions that have—in the past—caused core inflation. But the causes of inflation are extraordinarily complicated, and in many ways, they're very interconnected. During the next 10 years, we have to have some judgment on what the lending environment is going to be to get a sense of implications for inflation, but more importantly what the reaction mechanisms of the Fed will be. Will it be aggressive in combating rising inflation or take a more benign approach in the interest of protecting economic growth? MR: From an investor perspective, because the risk is there and it's prudent to plan for at least the possibility, is it fair to say that high inflation over the long-term is expected? LAS: Yes, I'd say that's fair, and I think along with that would be an expectation of generally an upward slope in terms of yields, which will be both related to the inflation story, but also the economy story. And that has implications for how investors think about the best places to have their money during the next decade. MR: You mentioned core inflation, which is the inflation rate excluding food and energy prices, and is something the Fed prefers to focus on when making its policy decisions. Why does the Fed do that, and how do we know which type of inflation is most likely to hit the United States? And, ultimately, does it really matter for investors? LAS: There are several reasons why food and energy prices are excluded. One, they tend to be highly volatile components and often we'll see some of the biggest price moves occur not because of the underlying causes of core inflation, but for more cyclical reasons. In the case of the recent spike in food prices, it had a lot to do with unique weather patterns. There have been massive floods in Australia, huge droughts in parts of Russia, Africa and South America; none of which are a secular or monetary phenomenon. In the case of oil prices, we've had the unrest in the Middle East recently and we've had supply disruptions in the past from man-made or natural causes. So the Fed tends to try to keep those volatile components out of the core inflation decision-making process because those are not monetary phenomena, while the Fed is there to control the monetary piece of this. Again, high commodity prices have an economic impact, but you have to try to be objective when judging whether it's going to have a monetary policy impact. MR: Rob, while we're on the topic of the Fed, this idea that the federal government has an incentive to inflate its way out of the massive federal debt is interesting. You've mentioned to me that if it were to happen, the interest rate on the debt would also expand pretty dramatically. What are your thoughts on that? Rob Williams: If the Fed were to try to inflate our way out of the federal deficit, that would lead to higher interest rates, which would increase the cost of paying the US debt, and there's very little incentive for the US Treasury, Congress or Fed to allow that to happen. So they've got built-in disincentives not to inflate our way out of the budget deficit. It's not a concern that we see right now. MR: The Treasury introduced Treasury Inflation Protected Securities (TIPS) in 1997 to help give bondholders a way to protect themselves against future inflation. Could you explain what TIPS are and how they work? RW: Sure. TIPS are Treasury bonds with built-in protection against inflation. The principal value of the TIPS that you buy is adjusted every year by inflation. If there's deflation, the value can fall within certain limits. And by inflation, we mean the Consumer Price Index as the general measure of inflation used to adjust TIPS. Like regular Treasury bonds, you're paid a fixed interest rate, but that rate is applied to the inflation-adjusted principal amount. So if we see inflation, the interest payments will rise, along with the value of principal that will adjust upward as well. So you'll receive the inflated interest payments and then, at maturity, receive the new inflation-adjusted principal value also. MR: Considering that TIPS have only been around since 1997, and we haven't had a period of rapidly rising inflation during the past 14-15 years or so, do you think TIPS will be effective and work as intended? RW: Yes, we've been discussing that we don't expect rapidly rising inflation in the short-term. TIPS haven't been tested in a period of rapidly rising inflation, but it's nearly certain that they will at least outperform regular Treasuries, if we do see a period where inflation is higher than the market expects currently. I think that's an important point. Liz Ann talked about monetary policy, and the complexity and uncertainty of anticipating what might drive inflation during the next 10 years. The expectation of future inflation is very important. Right now, the Fed is targeting about 1.5-2% inflation per year. Right now, if inflation does exceed those targets or those expectations, then TIPS are likely to outperform traditional Treasuries, even if we were to see a period of rapidly rising inflation. MR: Rob, do you view TIPS as more of a defensive investment that would protect on the downside, or do you think of them as an offensive instrument—something that will do extremely well if inflation were to rear its head? RW: You can use TIPS both ways. For most investors, TIPS were designed for inflation protection as a defensive investment, and we consider TIPS as a part of the portfolio for some level of inflation protection—not as an offensive, more-tactical investment. Bond portfolios and fixed-income investments, in general, don't do very well in inflationary environments, so TIPS are one of the few bond investments that provide some protection. Some investors use them as an offensive instrument. If you expect inflation to be higher than what the market currently expects (which, if we look at the yields and prices of Treasuries and TIPS bonds today, is about 2.5% or so inflation over the next 10 years), then TIPS prices could rise on increased demand in the short-term and outperform Treasuries. MR: TIPS are bonds, and we normally think of bonds dropping in price when interest rates rise. But usually when interest rates are rising, inflation is rising, as well. So if I own TIPS, either directly or through a mutual fund or an exchange-traded fund (ETF), what happens when both interest rates and inflation are rising? RW: This is a critical point, and many investors can confuse inflation with rising interest rates. They do tend to go together: When we see inflation, rates tend to rise in order to compensate investors. But TIPS are designed for inflation protection, not as a hedge or protection against interest-rate risk. In other words, if rates rise, TIPS can fall in value just like any other type of bonds because of the rising interest rate and the interest-rate risk involved. Over time, interest rates and inflation do tend to go hand-in-hand. It's not a perfect match, but over the longer-term, TIPS should provide some protection. MR: To highlight the larger point, when I'm constructing a portfolio, I've got to think about inflation risk, and I'd want to find some form of protection for that, but I'd also want to protect myself against interest-rate risk, which is different. RW: Yes, that's right, and there are other ways to protect against interest-rate risk. The most obvious is to shorten the average maturities or the average duration of your portfolio if you anticipate that rates will rise. Michael Iachini: If I can jump in for a second, I'm actually curious to get your perspective on something: If an investor is buying TIPS to protect against inflation, but intends to hold them to maturity—rather than being concerned with what the current price of their bond may be, which would the main piece of interest-rate risk—are TIPS a better hedge against inflation? RW: Right—for investors who buy individual bonds (including TIPS) to hold to maturity, a TIPS bond would provide a guaranteed level of return relative to inflation, whatever that inflation rate might be. And rising interest rates may not be as relevant if you're holding to maturity. The par value will rise with inflation, and you needn't be as concerned about short-term price fluctuation due to day-to-day interest-rate changes. So that type of investor may not be as concerned about the interest-rate risk we discussed. MR: Michael, we've been talking about TIPS primarily as an investment to buy and hold as an individual security, and yet one of the fastest-growing categories of mutual funds are TIPS funds and ETFs tied to TIPS indexes. Talk to me a little bit about those. MI: Sure. If you're interested in TIPS but don't want to buy individual securities, you could buy a mutual fund or ETF whose manager invests in TIPS, and there are many options out there. This also allows you to spread out your duration a little bit because some have longer and some shorter maturities. But in the simplest terms, they're a portfolio of TIPS, and the value of that portfolio will move up and down day-to-day depending on movements in interest rates in the market and perceived credit risk in different parts of the bond market. TIPS, being issued by the Treasury, are generally perceived as having almost no credit risk, but interest-rate risk will mean the value of the portfolio can move up and down. MR: Liz Ann, one of the things I hear repeatedly is different pundits suggesting that people look to overseas investments as a haven to protect against inflation. It seems as though they're making an implicit assumption that if the United States is experiencing inflation, then other countries won't be experiencing inflation. Historically, does that actually happen? And do you think that will be the case now if, at some point, we do see rising US inflation? LAS: Historically, that's happened at times, but what's happening right now is the emerging world actually experiencing a true core inflation problem, yet much of the developed world is not. We talked earlier about an environment of slack: If employees demand higher wages when corporations are operating with little spare capacity, those are the conditions that typically bring on generalized inflation. But there's a tremendous amount of slack—both labor and industrial—in the developed economies. That's very much the opposite of what's happening in the emerging would right now where there's not a lot of excess slack. They have very little excess industrial capacity and they're also experiencing the kind of upward pressure on wages that the United States experienced back in the '70s and early '80s, and that's contributing to a budding core inflation problem. In emerging markets, like China, we're indeed seeing a core inflation problem and that's leading the monetary authorities in China and elsewhere in the emerging economies to be in a tighter monetary policy stance. RW: I'd add to that because we've been talking about bonds, too. For some investors, having a portion of their portfolios in international bonds can help protect against currency risks and also provide some core inflation protection, as well. MR: Thanks, Rob. Liz Ann, some people have argued that the United States is exporting inflation to the emerging markets. What's your take on that, and is there any risk that there would be some mechanism in this increasingly integrated world that that inflation could get exported back to the United States? LAS: Typically, that argument surrounds the Fed's very loose monetary policy. I think there's legitimate criticism of QE2 (quantitative easing round two) and its contribution to the increase in asset prices—specifically in the stock market, but also in commodity markets. When you have all this excess liquidity, one of the implications is a weaker currency, and we've seen that with the US dollar. Given that a lot of commodities are priced in US dollars, a weaker dollar puts upward pressure on prices of these commodities. In that way, yes, you could argue that our very loose monetary policy has exported commodity inflation to the emerging markets and, unfortunately, because they have their own reasons to be increasing wages (trying to boost domestic consumption and keep social unrest at bay) that's causing a more core inflation problem. You could also argue that growth in emerging economies is supporting the demand prop under rising commodity prices. So, even if you're a critic of excess monetary policy by the US Fed, there are plenty of other reasons for commodity prices going up. And then you have the case of China, which basically has its currency pegged to the dollar, which means China is effectively adopting our very loose monetary policy, which arguably is not appropriate given its higher inflation risk right now. So your point about global interconnectedness is very important, but it's a bit circular and there are lots of ways you can judge what's happening presently in terms of the cause and effect of core inflation globally. MR: Michael, let's turn to some other investments that are often viewed not only as inflation hedges, but that also tend to thrive during periods of high inflation—gold and commodities being obvious examples. Are they as effective as advertised? MI: Sure. Gold and other commodities are generally, by conventional wisdom, seen as a good inflation hedge. That is, when inflation rises, the price of these commodities rises so if you're worried about inflation, you buy exposure to them and, therefore, even if inflation goes up, you'll have a piece of your portfolio that's going up, perhaps, just as fast or faster. And there is some truth to that. Gold and other commodities, like oil, or agricultural commodities, do tend to move more or less in line with inflation, but it's not a perfect relationship. There are periods where you'll see inflation rising and the price of these commodities falling or rising very slowly and vice versa, where inflation might be coming down and those commodities are going up in price. So it isn't a perfect hedge, but if you're interested in finding something that does tend to move with inflation, we've looked back over the past 30 years at correlations between inflation rates and the prices of these commodities, and in general, it's a positive correlation (meaning these prices tend to move together). So high inflation tends to go with higher commodity prices, whether that's gold or oil or some of the other commodities if you had a more diversified basket. But keep in mind it's not 100% effective, and you can have situations where inflation will rise and commodities won't—they might stay flat or they might rise only a small amount or even, in some cases, fall. So it's not a perfect correlation, but there is a positive correlation and that means that if you're worried about inflation, adding commodities to your portfolio—whether through an ETF or a mutual fund or some other vehicle you might have access to—can provide some protection against that inflation in most markets. MR: How volatile are gold and commodities as investments compared to the other inflation hedges we've discussed? MI: It's definitely true that gold and oil and other commodities have volatility in their prices. And as you compare them to something like TIPS, which have no real credit risk involved (although there is some interest-rate risk), you can't compare it. Over their short history, TIPS have exhibited very low volatility. Of gold, oil and TIPS, oil has been the most volatile of the three. Gold is second, but still much more volatile than something like TIPS. So if you're worried about a rollercoaster ride, the big ups and downs, you might prefer to start with something like TIPS as an inflation hedge rather than diving right into commodities, which will give you bigger ups and bigger downs. MR: Brad, let's talk about another classic inflation hedge: stocks. Over long periods of time, stocks are known as the one asset class that has higher rates of return than the typical inflation rates that we've experienced, and that's because companies can pass on price increases to consumers. But is that the case for all stocks? Are there segments of the market more likely to thrive during periods of rising inflation? BS: Yes, to your first point, that's interesting. Stocks have been proven to be a pretty effective tool against inflation, at least keeping up with inflation, and there are areas of the stock market that tend to do better than others during inflationary periods. On a sector level, those more exposed to commodities, the materials and energy sectors, have tended to do better. They've been able to pass along the price increases more rapidly. Conversely, consumer stocks have tended to do worse during inflationary periods, and that appears to be the case this time as well because they continue to have problems passing along their increased costs. Whereas with energy prices, as you can see at the gas pumps, companies are relatively better able to pass on those price increases. MR: Michael, let's wrap up our discussion with mutual funds. There are a lot of so-called real return mutual funds out there. Talk to me about them and what they're investing in. MI: When you have a real return fund—as opposed to nominal—that means you're still looking for return after you've factored in inflation. Generally speaking, real return funds tend to be actively managed products, and the managers within them have some flexibility as to which parts of those inflation-protected asset classes they feel are most attractive and give clients the best real return. There are a few funds out there that try to mix and match various inflation-protected returns. So you'll see them usually holding three pillars like TIPS, commodities and currencies. There could also be some bonds in there, too, of course, but maybe with a currency overlay to protect against a US dollar that's falling in value because of inflation. MR: Thank you all for joining me today. |
Thursday, April 7, 2011
To Be or Not To Be: That is INFLATION!
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