Inflation: When Price Is The Object

OCEAN CITY – The effects of short-term market volatility can be
frightening, but when it comes to planning for retirement, the real bogeyman is
inflation, says Joseph Zidle, Global Wealth Management investment strategist,
BofA Merrill Lynch Global Research.

For the past 25 years, inflation has averaged about 3% annually. While that
doesn’t sound very threatening, this steady increase in the Consumer Price
Index (CPI), the key measure of inflation, has eroded purchasing power by 52%
over the same period.

Given the modest pace of the economic recovery, along with the high rate of
unemployment, the Bank of America Merrill Lynch Economics team
does not expect broad-based inflationary pressures until at least 2012. Still,
for long-term investment strategies, it would be wise to build in some
protection against rising rates.

The first, and in some ways most fundamental, inflation-hedging strategy
you can use is allocating enough of your portfolio to equities. The reasoning
is simple: Historically, stocks outpace inflation. During the past 25 years,
for example, while inflation averaged 3% annually, stocks posted annualized
returns of 10.54%, according to Morningstar, Inc.

Probably the most direct hedge against inflation is an allocation to
Treasury Inflation-Protected Securities, or TIPS. Because the principal of
these U.S. government–issued bonds is tied to the CPI, as the overall cost of
food, health care and other everyday expenses rises, so does the amount you
will receive when these bonds reach maturity.

Although a bit more exotic, commodities can prove useful for protecting a
nest egg. Commodity prices are also highly responsive to inflation’s close
cousin, a weak U.S. dollar.

An increasingly popular way of increasing exposure to commodities is
investment in certain exchange-traded funds, which pool stocks of companies
that own or produce natural resources. Zidle also offers another creative
variation on this strategy: a broad equity allocation to emerging markets.

Real estate is generally considered an inflation hedge because, like
equities, real estate prices have historically risen with inflation. Of course,
the economic downturn has hit real estate hard, and few signs point to a major
recovery in the sector any time soon.

Some of the better-capitalized real estate investment trusts (REITs) have
taken advantage of low interest rates and refinanced their portfolios in the
past year, reducing their debt costs. They will most likely pass on their
savings to their shareholders in the form of higher share prices and dividend
yields. But investors must be selective, Zidle warns.

Yes, inflation-minded investors may also want to consider increasing their
exposure to foreign bonds. In the short-term, worries about sovereign debt
defaults may have spurred a flight to the safety of the dollar and U.S.
Treasuries, but when you extend your view out past the next six months or so,
the picture may look quite different. Eventually, America’s own deficit
challenges could exert more pressure on the dollar, potentially pushing up
prices in the U.S. and boosting the relative strength of currencies of
economies that have a better handle on their ratio of debt-to-GDP.

If economic forces collide after the next couple of years to ignite
inflation as a major issue, more investors will be looking to reallocate assets
to fend off the impact. Yet even if rising prices remain no more of an issue
than they’ve been for the past quarter-century, it may make sense to talk with
your financial advisor now about how best to incorporate some inflation-hedging
instruments into your investment strategy. Remember, when it comes to
inflation, it doesn’t take much.

Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)