Now that commodity prices have declined to multi-year lows and the U.S. dollar is picking up some momentum, U.S. inflation expectations are being depressed. If deflationary pressures persist, investors can turn to some assets and exchange traded funds to hedge risks.
The U.S. Federal Reserve tracks the five-year inflation expectations to guide its outlook. The so-called 5yr/5yr breakeven rate is currently hovering around 2.15%, its lowest level since September 2011, which was just before “Operation Twist,” and a little above the financial crisis low of 1.95% in December 2008, Financial Times reports.
“At current levels this indicator is bound to gain some attention among US officials, especially if it shows persistence at levels near 2 per cent,” Alan Ruskin, a strategist at Deutsche Bank, said in the article.
Albert Edwards, a noted bear at Societe Generale, warns that an “Ice Age” could grip the markets as the Federal Reserve and European Central Bank fail to prevent deflationary pressure.
Nevertheless, investors who are concerned about the risks associated with a deflationary environment have some ETF options available.
For instance, long-term bond ETFs will benefit. As prices decline, the real value of fixed-coupon payments look more attractive, and longer duration securities will typically outperform other bonds since their coupon payments are set for an extended period. The iShares 20+ Year Treasury Bond ETF (TLT) tracks long-term U.S. Treasuries with a 17.19 year effective duration and a 3.09% 30-day SEC yield. The Vanguard Long-Term Corporate Bond ETF (VCLT) follows investment-grade, long-term corporate debt with an average duration of 13.9 years and a 4.49% 30-day SEC yield.
While deflation is usually bad for stocks – profits will fall on lower prices, dividend-paying stocks and related ETFs may also be used as a way to hedge deflationary risks. The dividend yields act like coupon payments for bonds, and most companies are not in a habit of cutting dividends. For example, the PowerShares High Yield Equity Dividend Achievers Portfolio (PEY) , which track a group of stocks with consistent growth in dividend, has a 3.4% 12-month yield and the iShares Core High Dividend ETF (HDV) , which includes high quality U.S. stocks with attractive yields, comes with a 3.15% 12-month yield. [A Dividend ETF with Consistently Sturdy Yields]
As prices dip, the purchasing power of the dollar improves. Consequently, investors can also look at ETFs that act as cash alternatives, such as short-term bond ETFs. The actively managed PIMCO Enhanced Short Maturity ETF (MINT) has a 0.46% effective duration and a 0.47% 30-day SEC yield, and the Guggenheim Enhanced Short Duration Bond (GSY) has a 0.47% effective duration and a 1.03% 30-day SEC yield. [No Free Lunch with Ultra-Short-Term Bond ETFs]
For more information on the changing consumer prices, visit our inflation category.
Tom Lydon’s clients own shares of TLT.