Investing: A little inflation isn’t such a bad thing

June 28, 2011

We’re in a three-headed hydra economy now. There’s the threat of burgeoning inflation, joblessness and a rotten housing market.

Yet the idea that rampant inflation will trigger an investment debacle is perhaps overblown. A touch of inflation can be a good thing and it depends on how you invest.

I’m not discounting the possibility of a bond bubble bursting, so be sure to shorten your maturities on high-quality bonds because they will get hardest hit by any interest-rate increases. Beyond that, the news may not be all that bad based on historical results for stocks.

Consumer inflation is running at a nearly four percent clip, according to the latest government report, which shows the annual rate at its highest since June, 2008. The bulk of the increase was in energy (fuel prices — up 21 percent) and food.

A little inflation isn’t that toxic to stock returns. According to research from the Leuthold Group, stocks often gain in periods of mild inflation. The last time inflation was climbing at least three percent, stocks did just fine. Leuthold found that in September, 2000; September, 1996; and June, 1995, the subsequent one-year performance of stocks was 13 percent, 20 percent and 26 percent, respectively.

Although there are exceptions to these trends — December, 2002 had a one-year trailing decline of 22 percent (recession-induced) — the overall conclusion is that “in those periods of mild inflation 45 of 53 periods (going back to 1926) had positive [stock] returns.”

What happens if inflation creeps substantially over the three percent threshold? Only four of those periods in the Leuthold study showed gains. One thing is fairly certain: Stocks generally don’t do well during high-inflation times. In the 1970s, when inflation averaged 7.4 percent — it was double that toward the end of the decade — stocks only rose about five percent, according to Ibbotson Associates. That compares to an 18 percent average stock performance for the 1990s, a decade in which inflation averaged less than three percent.

No one quite knows where inflation is going. Will energy prices stay high or will a continuing millennial malaise in the U.S. and Europe trigger another slowdown? Will wages ramp up if the economy goes in the other direction? What’s going on in China, where inflation is picking up?

If you’re on an inflation watch every month, following the predictions and consumer price index reports could drive you crazy. I suggest following corporate earnings and capitalize on growth through exchange-traded funds. Here are some quick routes to gains in a low-inflation environment:

Dividend funds
Look for mature companies that have solid earnings, pay and increase their quarterly dividends. One way of tracking a basket of these companies is through an ETF like the SPDR Dividend fund. While the 3.25 percent yield doesn’t sound like a big deal, it’s roughly three times what you’d get on a one-year certificate of deposit. All dividend funds, however, are subject to market risk. There’s nothing secure about those returns, but they will track consistent dividend payers that may not get walloped by a slight uptick in inflation.

Energy funds
You certainly won’t be able to beat these companies at the fuel pump, but you can invest in them as energy prices rise. A fund like the Vanguard Energy ETF, invests in oil and natural gas producers.

Emerging markets
If modest inflation is linked to economic growth, worldwide trends favor multinationals and non-U.S. companies. The iShares MSCI Emerging Market Index gives you a broad sampling of these companies.

All bets are off if industrialized economies enter a “stagflation” mode of no job growth and rising inflation, as was the case in the late 1970s and early 1980s. That would hurt stocks in the long run. Leuthold notes that “higher inflation could mean lackluster stock performance during the second half of 2011.”

The specter of a double-dip recession in the U.S. and Europe also bodes ill for stocks in general. After all, the narrative continues on how to fix Eurozone and American debt woes. The monster is not back in the cave on those issues, so you need to be careful.

5 comments

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Like back in the 1980’s when it was in the double digits?

Posted by Prue | Report as abusive

I don’t see how inflation can ever be a good thing for the economy. It means that the dollars you earn are worth less in terms of what they will buy. You can keep up with it as long as you continue to make money and as long as you can keep getting a salary raise. However, for many people on fixed incomes it means that they can’t buy what they used to.

Posted by zotdoc | Report as abusive

John,

Inflation may not hurt investing but is slowly draining the lifeblood from those who should be investing more – in their own retirement future. And that will impact every corner of the marketplace from the grocer to Wall Street now and 20 years from now, rate or no rate. I’m not sure inflation could get much higher and still be something of passing consideration. It has successfully crept into every consumer driven product and that I believe, includes stock prices.

Posted by PaulPetillo | Report as abusive

Please don’t get me wrong. I’m no fan of inflation. It does reduce purchasing power for the most vulnerable. As long as you can keep up with it somehow, it needn’t be punishing.

Posted by johnwasik | Report as abusive

Inflation is ALWAYS a bad thing. Deflation is much better. It means our purchasing power goes up … each dollar can buy more, whether it’s food our a house. Inflation is only good for one thing: allowing the government to steal more of our money via taxes.

Posted by Billw13175 | Report as abusive

[…] of commentary in recent months about the possibility of reducing the nation’s debt by means of inflation. Simply put, a dollar of today’s debt can be repaid with a dollar sometime off in the future. If […]

Posted by The case for financial repression: mild inflation, low interest rates | Reuters Money | Report as abusive