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Investors should worry about inflation risks Original Source Link: (May no longer be active)
http://www.reuters.com/newsArticle.jhtml?type=businessNews&storyID=4562829http://www.reuters.com/newsArticle.jhtml?type=businessNews&storyID=4562829
Investors Should Consider Inflation Risks
Sun Mar 14, 2004 10:27 AM ET
By Clint Willis
PORTLAND, Maine (Reuters) - Investors haven't worried much about inflation in recent years, but some analysts believe the threat of a sharper pickup in prices is increasing.
A higher rate of inflation is bad for the financial markets, in part because it reduces the purchasing power of future dividends from stocks and future interest payments from bonds. Fortunately, you can take steps to protect your portfolio by putting more money in funds that are less vulnerable to inflation and avoiding those that are likely to suffer the worst declines in an inflationary environment.
A year ago, some economists were concerned about deflation -- falling prices that could wreak havoc on the global economy and financial markets. Recently Federal Reserve Board Chairman Alan Greenspan indicated that he believes that risk has abated, but hasn't disappeared entirely. If the global economic recovery stumbles, deflation fears could be back in the headlines.
For now, however, inflation is more of a worry. Some economists say the government's efforts to avoid deflation could cause a surge in prices that would pummel both bond and stock markets.
Your fund portfolio should reflect that risk and provide some protection against inflation's more insidious long-term threat. "Inflation should be a big concern for investors," says Simon Heslop, a financial analyst in Concord, New Hampshire.
Several factors have helped quell deflation fears and increase the risk of inflation during the past year. The government still engages in massive deficit spending, pumping billions of dollars into the economy, especially defense. Meanwhile, the Bush administration has sponsored tax cuts to try to stimulate economic activity.
The Federal Reserve Board also has played a role in the turnaround by keeping interest rates low to stimulate the money supply, a key element in any economic rebound. And the falling dollar has made U.S. goods and services cheaper for overseas buyers, stimulating demand for exports.
These factors haven't yet ignited a powerful economic recovery, and the rising deficit could pose problems for the economy's long-term health. Few economists are therefore forecasting a sharp increase in the rate of inflation during the coming year, but most acknowledge that the risk of a sudden rise in prices has increased.
Fortunately, you can take a few simple steps to protect your fund portfolio.
Begin by evaluating its exposure to a sudden run-up in the inflation rate.
Certain funds are especially vulnerable. Rising prices typically lead to higher interest rates, which generally causes long-term bonds, for example, to lose value.
You can measure that risk by finding out a fund's duration -- information the fund company should be able to provide. A duration of one year means the fund's price should decline roughly 1 percent for every percentage point increase in interest rates.
You can reduce your short-term inflation exposure by trimming your exposure to bond funds with durations higher than six or seven years.
You might decide to replace them with intermediate-term bond funds, which typically have shorter durations of around four or five years. Such funds include Vanguard Intermediate-Term U.S. Treasury (800-662-7447; $3,000 minimum investment; no load) and Thornburg Limited-Term U.S. Government (800-847-0200; $5,000 minimum; 1.5 percent load).
Funds that invest in growth stocks -- shares of companies whose earnings are expected to increase sharply -- also are vulnerable to short-term blips in the rate of inflation. Investors worry that rising prices will reduce the future purchasing value of their returns from such stocks.
One solution: Consider shifting a modest sum from growth funds to funds that provide a hedge against short-term inflationary run-ups.
Among such inflation hedges are funds that invest in real estate investment trusts. These include Alpine U.S. Real Estate (888-785-5578; $1,000 minimum investment; no load) or Security Capital U.S. Real Estate (888-732-8748; $1,000 minimum; no load).
Funds that invest in commodities or natural resources also can provide a hedge against inflation. These include T. Rowe Price New Era (800-638-5660; $2,500 minimum; no load), which holds stocks in the oil and gas, metals and utilities sectors.
Also look at bond funds that invest in Treasury Inflation-Indexed Protected Securities, which provide higher yields when inflation rises so their value doesn't tend to decline when prices rise.
Among the funds that invest significant stakes in inflation-indexed bonds are the PIMCO Real Return Fund (888-877-4626; $2,500 minimum; 3 percent load) and American Century Inflation-Adjusted Bond (800-345-2021; $2,500; no load).
(Clint Willis is a freelance writer who covers mutual funds for Reuters. Any opinions in the column are solely those of Mr. Willis.)
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