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Investors, Inflation-Proof Your Assets

Anne Kates Smith, Senior Editor, Kiplinger's Personal Finance
Keep higher prices from nibbling away at your portfolio.

Until recently, investors haven't had to worry much about inflation. Rather, the threat of deflation--persistently falling prices--has been the more pressing concern for several years. But like the proverbial frog oblivious to the rise in water temperature until it's too late, says Russ Koesterich, a portfolio manager at BlackRock, investors are starting to experience a stealthy increase in prices.

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The consumer price index rose 2.1% in 2016, way ahead of the 0.7% rise in 2015 and the 0.8% increase in 2014. One key reason is the rebound in oil prices, which have climbed from $27 a barrel in early 2016 to $53 today. Housing costs are rising at the quickest pace in nearly 10 years (see Home Prices Keep Climbing), and medical costs, which had been mostly moderating since 2008, are ticking higher again. Overall, Kiplinger sees consumer prices rising 2.4% in 2017.

The new president will surely keep inflation on the front burner. "Donald Trump has put forward a set of ideas that may involve higher fiscal deficits, a large infrastructure build-out and protectionist trade policies, all of which could support higher inflation," says Orhan Imer, who specializes in inflation-linked strategies at Columbia Threadneedle Investments.

No one is talking about a return to the double-digit inflation of the late 1970s. Interconnected global markets and technological innovations that improve productivity are powerful forces for holding down price increases for goods and services. But that doesn't mean you can let your guard down. "Even low levels of inflation can be an insidious drag on your portfolio and erode your buying power," says Joanna Bewick, comanager of Fidelity Strategic Real Return Fund (symbol FSRRX). Investors who have not done so already should consider protecting against such erosion with some of these in­flation hedges.

What to buy. Among your bond holdings, consider adding Treasury inflation-protected securities. The principal value of these government issues is adjusted each month to keep pace with inflation--so yields of 0.4% for TIPS maturing in 10 years look paltry before you add the inflation rate. You can buy TIPS directly from Uncle Sam at www.treasurydirect.gov. Plan on holding your TIPS until they mature.

Investors who don't hold the bonds to maturity or who invest via funds should be aware that TIPS prices, like those of most bonds, fall when interest rates rise--which is what normally happens when inflation is accelerating. Given Kiplinger's forecast for higher rates in 2017, fund investors should focus on portfolios that invest in short-term TIPS. Those funds will yield less than those that own longer-term TIPS, but they will be less sensitive to rate swings. A good choice is Vanguard Short-Term Inflation-Protected Securities (VTiPX) or its exchange-traded namesake (VTIP, $49). Yields for both versions are negative, but the funds should deliver positive returns once the inflation adjustments are made. (Prices and yields are as of January 31.)

You can take advantage of the higher rates that go hand in hand with inflation with a floating-rate fund. Such funds hold debt with rates that adjust along with a short-term benchmark. Many of these funds invest in loans made by banks to companies with substandard credit ratings. But with the economy growing, defaults should remain manageable for now. Fidelity Floating Rate High Income (FFRHX, yield 3.3%) and PowerShares Senior Loan ETF (BKLN, $23, 2.6%), a member of the Kiplinger ETF 20, hold securities that are a little higher in quality than some of their peers. If you want to minimize credit risk and are willing to accept a lower yield, try IShares Floating Rate Bond ETF (FLOT, $51, 1.1%), which holds bonds with investment-grade ratings.

Stocks will crater if there's an in­flation shock--something on the order of an oil embargo or food crisis--but should beat inflation over the long haul. However, some stock sectors do better with inflation than others. InvesTech Research, a market research firm, looked at eight periods of accelerating inflation from 1950 through 2012 and found that energy, materials and industrials stocks, among the most sensitive to swings in the economy, were top performers; rate-sensitive sectors such as utilities and telecommunications lagged the market. When consumers are watching every penny, "you want to go with companies that have good brands and a competitive advantage, that can raise prices and make them stick," says Chris Zaccarelli, chief investment officer at Cornerstone Wealth, based in Charlotte, N.C.

Think companies such as Apple (AAPL, $121) and Walt Disney Co. (DIS, $111). Strategists at Goldman Sachs recommend companies with low labor costs as a percentage of revenues; their bottom lines won't suffer as much as those of high-wage firms as pay rises. The group includes insurer Aflac (AFL, $70), food processor Archer-Daniels-Midland (ADM, $44), pharmacy benefit manager Express Scripts (ESRX, $69) and homebuilder PulteGroup (PHM, $22).

Commodity prices respond quickly to increases in demand when the economy is growing. They're often the first signal of rising inflation, as well as a hedge against it. The downside is their notorious volatility. Commodity prices have been on the upswing since early 2016, reversing a nearly 50% slide from April 2014. Harbor Commodity Real Return Strategy (HACMX) is a commodity fund with a twist. Its managers use some of the fund's assets to buy derivatives that track the prices of oil, metals and agricultural commodities. With the rest of the assets, they assemble an actively managed portfolio of TIPS and other bonds. You can gain exposure to commodities indirectly via SPDR S&P Global Natural Resources ETF (GNR, $43), which holds stocks in the energy, agriculture, and metals and mining sectors.

You may be surprised to learn that gold is not the inflation hedge it's cracked up to be. It has outpaced in­flation only about half the time in successive 12-month periods starting in December 1973. Still, if inflation expectations accelerate sharply, gold, which also provides portfolio protection in times of geo­political upheaval, would likely perform well, says BlackRock's Koesterich. Consider putting a small amount of assets in a low-cost exchange-traded product, such as iShares Gold Trust (IAU, $12), which charges 0.25% annually.

Real estate is a classic inflation hedge, as anyone who owns a home is well aware. You can also own real estate indirectly, through a real estate investment trust that owns commercial properties. REITs give investors a twofer in times of rising inflation, says Kevin Brosious, an investment adviser in Allentown, Pa. The value of the underlying real estate appreciates along with inflation, while rents paid by tenants rise, too. One fund worth a look is T. Rowe Price Real Estate (TRREX, 2.3%), whose manager, David Lee, has been at the helm since 1997. He seeks REITs that he thinks will grow consistently and that trade below the value of their underlying assets. If you prefer an indexed approach, check out Schwab U.S. REIT ETF (SCHH, $41, 3.3%), a member of the Kiplinger ETF 20. It charges just 0.07% annually.

Fidelity Strategic Real Return offers a one-stop inflation solution. The fund, which yields 1.0%, has roughly 30% of its assets in TIPS, 25% in floating-rate loans, 25% in derivatives that track prices of a basket of commodities (split evenly among energy, metals and agricultural products) and 20% in real estate-linked stocks and bonds. The fund's 10-year return of 2.4% annualized won't blow you away, but its four-pronged strategy, tested back to 1973, would have beaten inflation in 81% of 12-month periods.

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Copyright 2017 The Kiplinger Washington Editors