Inflation Protection: No Guarantees

The threat of inflation is drifting through the collective consciousness of investors these days. But will the inflation-protection investments so many are turning to work as advertised?

Though the widely watched consumer-price index was down 1.5% in the 12 months through August, in blogs, newsletters, online chat rooms and elsewhere, institutional investors, economists and others are wringing their hands. They're warning that the vats of stimulus money and credit that governments are pouring into economies world-wide will, at some point, result in rising prices for goods and services. Warren Buffett, the heralded investment oracle running Berkshire Hathaway Inc., wrote in an August editorial in the New York Times that the unchecked dumping of dollars into the U.S. economy "will certainly cause the purchasing power of the currency to melt." That means inflation.

Worried investors have been looking for insurance in the form of assets such as mutual funds and exchange-traded funds focused on gold, commodities and Treasury inflation-protected securities, or TIPS. In the past year, interest in TIPS funds in particular has been running at record levels, with some weeks recording more than $400 million in sales.

But many of these investments have never been tested during a bout of meaningful inflation. The last time inflation ramped up significantly was three decades ago. Yet TIPS have been around only since the late 1990s, and commodity funds are of even more recent vintage, as are the gold funds that invest in bullion or track the metal's market price.

So investors are taking it on faith that these investments will perform as expected. "There's no guarantee with any of them," says Christian Hviid, director of asset allocation at Genworth Financial Asset Management.

Indeed, there are reasons to believe that some investors are likely to be disappointed. To understand the pros and cons and potential risks of popular inflation-protection strategies, consider how each works:

TIPS and TIPS Funds

TIPS are designed to track changes in the monthly CPI, as reported by the Bureau of Labor Statistics. If the CPI rises, the securities' principal, or face value, increases. That increases interest income for the holder—because the interest is set as a percentage of the principal—helping investors keep pace with rising prices. Plus, when the securities mature, investors get back the CPI-adjusted principal.

For many investors, TIPS appear to be the purest form of inflation protection, since they are the only asset explicitly tied to an inflation benchmark.

But that raises a key question: Does the CPI accurately reflect inflation? "No," says Paul Brodsky, a partner at QB Asset Management. "The CPI is deeply flawed. It is not an accurate indication of how much purchasing power a dollar loses."

The index, for instance, doesn't reflect borrowing costs. When the Federal Reserve raises interest rates, rates on credit-card balances and other adjustable-rate loans rise, and consumers must spend more to pay off their debt or support a lifestyle funded with credit cards. And there are other quirks: When airlines lower prices, that is captured by the CPI, yet when they impose a $25 surcharge for luggage, that is not. Your own mix of expenses could also be very different from the one the benchmark uses.

So, in terms of both the interest payments and the principal returned, TIPS could disappoint investors expecting these securities to help them preserve their purchasing power.

Moreover, the market value of TIPS won't necessarily perform as expected. That could lead to losses for investors who own TIPS directly and sell them before maturity, or for investors in TIPS funds.

Amid nascent inflation, TIPS prices would likely perform better than those of regular Treasurys, as investors rush to own inflation protection. Once the Fed responds by raising interest rates, however, TIPS already in the market would begin to lose some luster, just like regular Treasurys. After all, if a new TIPS offers a yield of, say, 5%, investors would have little interest in older securities yielding 3%. The market price of those older TIPS would fall, which could result in losses for investors who own them and decide to sell.

Of greater concern is what happens to TIPS if the market or the Fed is particularly aggressive in pushing up interest rates.

That's a scenario reminiscent of the late 1970s and early 1980s, when the Fed quickly shoved interest rates as high as 20% at a time when inflation as measured by the CPI was running in the low teens. A similarly aggressive move wouldn't be good for Treasurys in general, but it would be particularly bad for TIPS, say bond-market pros, because it would mute inflation expectations, leaving investors less willing to pay for the inflation protection offered by TIPS.

Gold Funds

Though long heralded as a hedge against inflation, gold hasn't always gone along for the ride when U.S. consumer prices are rising. Consider data from Morningstar Inc.'s Ibbotson Associates research and consulting unit: The correlation of spot gold prices to an Ibbotson-tracked inflation benchmark is just 0.096. (Correlation is perfect at 1; the closer to 0, the less the correlation.)

Certainly, gold has done well in some inflationary periods, like the late 1970s, when the metal spiked above $800 an ounce. Still, investors would do better to view gold as an international currency that hedges against weakening paper currencies, particularly the dollar. For instance, the U.S. dollar index, tracking the greenback's performance against a basket of currencies, has slipped more than 13% since March, when the index hit its peak so far for this year. Gold prices, meanwhile, are up more about 14% so far this year.

The current rally in gold prices is driven in part by growing worries about a weakening dollar tied to the expanding U.S. budget deficit and the outsize obligations the U.S. has in its Social Security and Medicare systems. But that sentiment could reverse, particularly if investors perceive that political leaders and economic policy makers have a grasp on the problem. In that situation, the dollar could strengthen and push down the price of gold, even if inflation is heating up.

Moreover, many economists expect the Fed to react slowly to rising prices, to ensure the economy doesn't tip over again, and then play catch-up by aggressively pushing interest rates higher. Depending on what central bankers are doing globally, rising rates in the U.S. typically make the dollar more attractive to overseas investors and currency traders. In that scenario, buying pushes up the dollar and "gold will get knocked down," says Chuck Butler, president of online financial-services firm EverBank World Markets.

And because bullion generates no income, gold also would become less attractive as interest rates rise.

But there's another issue: What does your gold fund own?

Exchange-traded funds such as SPDR Gold Shares and related trust products such as Canada's Central GoldTrust own physical bullion, held in secure bank vaults and regularly audited.

Others don't own physical gold and instead seek gold exposure through derivatives. PowerShares DB Gold, for instance, tracks an index of gold-futures contracts. The risk there is that the fund faces possible counterparty woes. In a major market dislocation, not unlike the credit crisis, if investors on the opposite side of a trade fail to make good on their obligations, "there is risk that the expected price change in some commodity-proxy funds won't be delivered," says QB Partners' Mr. Brodsky.

Invesco Ltd.'s Invesco PowerShares unit referred questions about the fund to Deutsche Bank AG, which declined to comment.

Investors also frequently choose funds that own shares of gold-mining companies for inflation protection. Shares of the gold miners do generally rise alongside gold prices; in the past year, the Dow Jones U.S. Gold Mining Total Stock Market Index is up 26%. But, besides the fact that gold prices don't always track inflation, there's another reason for investors to beware of these funds. Though gold miners own vast sums of gold in the ground, their share prices are affected by events ranging from governmental actions to earnings forecasts to various corporate troubles, meaning the companies could underperform even as gold prices rise.

Commodities Funds

Commodities include food staples such as wheat, corn, sugar and soybeans; industrial metals such as nickel and copper; and energy resources such as coal, oil and gas. These products account for about 40% of the CPI, so they track the movement of the index well.

Investors can speculate on commodities using futures contracts, but that can be a challenge for individual investors. Commodity-focused mutual funds and exchange-traded products have sprung up in recent years, and for the most part they've done a good job of reflecting the ups and downs in the commodity markets.

However, investors need to be careful about exactly what they're buying. "The word 'commodity' in a fund's name should not be the end of your research," says Scott Burns, director of ETF analysis at research firm Morningstar.

One potential problem: Unlike a gold fund that can easily own and store bars of metal in a vault, commodity funds can't easily own commodities—agricultural commodities are perishable, and industrial commodities would consume far too much space. Instead, the funds use derivative investments such as futures contracts, which the funds roll over from month to month—continually selling contracts as they near expiration and buying new ones.

While commodity funds generally make money when commodity prices are rising, in certain situations that isn't the case because of a phenomenon known as contango. That's when futures prices are higher than the spot price for a commodity. In that situation, a fund ends up selling expiring contracts at a lower price and then reinvesting the money in higher-priced contracts—only to watch prices of the new contracts slide in value as the next expiration approaches.

"Effectively, the fund is always selling low and buying high," says Bradley Kay, an ETF analyst at Morningstar. So even though the underlying commodity is rising in price, "the fund could be losing money every time the contract rolls over."

Many commodity-based securities are exchange-traded notes, or ETNs, which pose a different risk. Unlike ETFs, which generally own a pool of hard assets or securities, ETNs own nothing. They are promissory notes issued by a bank, meaning they're unsecured debt; the return you earn is calculated based on the movement of an underlying commodity index.

"You're loaning money to a bank, and the bank pays you the return of the underlying index," Morningstar's Mr. Burns says. So long as the bank is healthy, no worries. But if it fails, you're in the pool of creditors hoping to recoup your money. Lehman Brothers, Mr. Burns notes, "had a few ETNs when it went under," two of which tracked commodities. Those ETNs were delisted and their holders became Lehman creditors.

China was the world’s second biggest energy user last year after the United States. The third and fourth largest energy consumers were the EU and Russia. Figures from British Petroleum show China accounted for an 18 % share of global energy consumption in 2008. China’s most important energy source remained coal (70 %), with China accounting for 46 % of the total world consumption. China satisfied 19 % of its energy needs with oil, and accounted for 10 % of world consumption (making China the world’s second biggest consumer of oil after the United States). China’s heavy reliance on coal recently made it the world’s largest carbon dioxide and sulphur-dioxide emitter. The easiest way for China to reduce air pollution would be to replace coal with cleaner energy sources. For example, natural gas produces 45 % less CO2 emissions than coal, practically no SO2, and lower NOx emissions. Natural gas satisfies just 4 % of China’s energy consumption at the moment.

What has quantitative easing ever done for us? For the British who ask that question, the list offered by the Bank of England seems to lengthen every day: lower government-bond yields, the revival of the corporate-bond market, lower unemployment and the rally in the stock market — in fact, pretty much anything good happening in the U.K. right now short of the balmy autumn weather. All that is missing from the list is a revival in bank lending and an increase in the money supply, the very things the BOE originally said its policy of buying government bonds was supposed to deliver.

The BOE's endlessly shifting justification for its easing policy is fueling fears in the markets that the BOE doesn't really know what it is doing or how to stop. The uncertainty is partly to blame for the recent weakness in the pound. As a result, next month's meeting of the Monetary Policy Committee, when it must decide whether to expand or halt its £175 billion ($284.7 billion) program, is taking on particular significance. The BOE's credibility and independence is increasingly at stake.

With the economy recovering and inflation proving surprisingly sticky, any decision to expand quantitative easing will need careful explanation. So far, the BOE has stressed that the amount of slack in the economy will keep a lid on inflation. But many economists now predict inflation will be above the BOE's 2% target next year, suggesting that policy may soon need to be tightened.

The BOE has confused the market by repeatedly focusing on lower yields on gilts — government bonds — as a key measure of quantitative easing's success. To the extent that this easing raises inflation expectations, ultimately pushing up gilt yields and requiring the BOE to print yet more money, this is a dubious argument. It also reinforces the suspicion that the BOE's implicit aim is to use quantitative easing to support the government's borrowing.

This would hardly be surprising. The budget deficit is likely to hit 13% of GDP next year, the second highest after Ireland in the industrialized world. Gilt issuance in 2008-10 is projected to be greater than in the previous 10 years combined. The market may be able to absorb issuance on this scale without quantitative easing. Private-sector saving is rising rapidly, creating funds for investment, and new liquidity rules will force banks to buy more gilts. But with 30% of demand for gilts typically from overseas, the BOE must fear what happens if foreign demand dries up.

Absent any serious attempt to address the fiscal position, stopping quantitative easing risks at best a rise in market rates and at worst could lead to a sterling crisis. Perhaps it can duck the issue next month by announcing a pause. But if inflation continues to rise, this will be a temporary respite. Sooner or later, the BOE must come off the fence.

Will World Food Prices Resume their Sharp Increase?

The worldwide recession has slowed the growth in the demand for cereals and other foods as many countries have experienced stagnation or contraction in their GDPs. Now that the recession appears to be over, world GDP will start growing again. Many are forecasting that this growth in world output, especially the growth in developing nations, will put sharp upward pressure on food prices and that of oil, natural gas, and other commodities. Even the Malthusian specter has been raised again that the growth in world population will exceed the capacity of the world to produce the food demanded to improve living standards in the developing world.

The sharp increases in food and other commodity prices during the period from 2002 to 2008 when world GDP was growing rapidly tends to support these fears. The World Bank's index of world food prices increased by 140 percent from 2002 to the beginning of 2008, and by 75 percent after September 2006. The price of oil went up more than fourfold from the beginning of 2002 to its peak at over $145 a barrel during mid 2008. At that time there were many predictions of oil going to $200 a barrel rather quickly, and also of food prices continuing to rise rapidly. The world recession clearly made these predictions obsolete, at least until world GDP begins to grow again.

Rapid growth in world GDP will put strong upward pressure on some commodity prices. However, the supply responses of exhaustible resources, like oil and natural gas, should be distinguished from the supply response of food production. The supply of fossil fuels is obviously ultimately limited by the amounts in the ground. Outputs of oil, coal, and other fossil fuels can be increased by new discoveries, such as the recent discovery of oil off of Brazil, by extracting more of these fuels out of existing fields, and by squeezing oil and other fuels out of shale and other rock formations. Yet, all these ways combined have rather limited effects on total output. This is why, along with OPEC's restrictions on oil output, long run supply responses of oil, gas, and coal to changes in their prices are usually estimated to be quite modest. The long run elasticities of supply in response to rises in the prices of fuels are about +0.4 to +0.5.

The short run response of world food production to increases in food prices may not be large either, although farmers can shift rather quickly among the production of corn, soybeans, wheat, and other crops. In the long run, however, world production of food is quite sensitive to the world price of food. Given time to adjust, farmers can substantially increase the production from given amounts of land devoted to farming by greater use of fertilizers and capital equipment. Higher prices encourage investments in discovering mew methods of improving farm productivity, such as corn and other hybrids, the green revolution, and genetically modified foods. Productivity advances in agricultural output were very rapid at many times during the past century, often outstripping advances in manufacturing and other sectors.

The amount of land devoted to farming in most countries declined drastically during the past century as urban sprawl, highways, and other land uses took over much of the land formerly used to farm. In the United States, farmers comprising less than 2% of the labor force and using well under half the available land, produce enough farm goods not only to contribute most of the food that feeds the huge American population, but these farmers also export corn, soybeans, wheat, and other farm goods all over the world. With high enough food prices, financial incentives will encourage farmers to take some land back from suburban, ethanol production, and other non-food uses.

World prices of food generally declined during the 20th century when world population and world GDP per capita grew enormously. The reason for these diverse trends is that productivity in the production of food expanded at a more rapid rate than did the demand for food. The advances in production were due to the use of new and more effective fertilizers, better farm machines, and many applications of scientific knowledge to improving the productivity of agriculture. Developed countries spent considerable resources on subsidies to farmers to help keep their prices up, not down. Even though it may not be possible to predict the exact nature of future agricultural innovations, one can reasonably expect similar growth in world farm output during the next several decades, especially if food prices rise by a significant amount.

Rapid growth in future world GDP is likely to greatly raise the prices of oil and other fossil fuels, unless concerns about global warming induce major steps to reduce the demand for these fuels. Rapid growth in world output is also likely to sharply raise the demand for cereals, meat, and other foods in developing countries. However, I have tried to show why food is different from fossil fuels and minerals, like copper, in that the supply of food is not limited by natural bounds on overall quantity. Rather, the efforts and ingenuity of farmers and researchers are able to greatly increase world food supply to meet even very large increases in the world demand for food.