STRATEGIES TO COMBAT INFLATION AND RISING INTEREST

With the second round of quantitative easing (QE2) concluding in June, the specter of much higher inflation looms. Already, signs appear that inflation might soon be on the rise. Over the past couple of years, commodities prices have risen significantly. Oil prices are approaching $120/barrel with $5/gallon gas prices on the horizon.

But a counter argument has circulated that despite this price acceleration, inflation will remain docile. Milton Friedman, the late economist, concluded that inflation is always a monetary phenomenon based upon variables such as wages, money supply and GDP growth rates. Currently, all three remain benign factors and inhibit the rise of inflation. Furthermore, housing prices, an important ingredient to the inflation equation, show little sign of recovery rendering this important sector a suppressant as well.

The aggregate effect of these conflicting domestic variables on inflation is difficult to measure. In addition, the effect of external factors such as the Japan earthquake, upheaval in the Middle East and the continuing saga of sovereign debt problems in Europe is a complication. We are in uncharted waters and any attempt to assess the possible economic impact of all these events is problematic at best.

In order to determine the factors that have resulted in price escalation, a close examination of the deep rooted causes is essential. First, recent price increases in some sectors are largely the result of the declining dollar. For example, most energy analysts have determined that since oil is bought and sold in dollars, the weakening of the dollar and not the turmoil in the Middle East represents the primary cause for skyrocketing prices.

Second, whether or not inflation accelerates, long term interest rates seem likely to rise. As QE2 ends and the economy continues to improve, long term interest rates should begin to track upward. Recently, Bill Gross of PIMCO sold the Treasury bonds in his flagship fund due to this concern. Meanwhile, many investors have responded to the likelihood of rising interest rates by bailing out of fixed income and re-positioning funds into riskier assets such as stocks and commodities.

Despite the obvious benefits of low interest rates to many sectors of the economy such as real estate, the deleterious impact to retirees who require safe higher yielding assets to live can be devastating.

Seniors are experiencing a dilemma as they decide whether to wait for rates to rise before investing or experience possible deterioration in their bond portfolio should they decide to invest in higher yielding long term bonds now. The conventional strategy of allocating a higher percentage of investable assets in investment grade corporate and Treasury bonds during retirement is simply too risky in this current economic environment.

There are a few strategies for income oriented investors to consider in this climate. In order to take advantage of the declining dollar, allocations to asset classes that benefit from both possible currency gains and higher interest rates abroad should be pursued. Meanwhile, the prevailing low interest rates have shifted the focus of many yield seeking investors toward stocks. As high GDP growth rates are sustained in emerging markets, many multi-national corporations have bolstered revenue by focusing on increasing exports to these countries. As a result, it is possible that dividends from these stocks could not only be maintained but possibly increased. When exploring domestic fixed income options, consideration should be given to securities with variable interest rates that defuse interest rate risk. Other possibilities are hybrid bonds, such as high yield and convertibles, where price movements are often more impacted by the stock market rather than by interest rates. Finally, much recent attention has been directed toward the opportunities in mortgage REITs where the lingering effect of depressed mortgage values from the sub-prime meltdown has resulted in very attractive yields.

In an economy where interest rates continue to hover near historic lows with a threat of renewed inflation, it is imperative that the search for relatively safe income vehicles be accompanied by a diligent analysis of risk. The ramifications of a major miscalculation could have effects that last a lifetime.

Best Wishes,Clifford L. Caplan, CFP®, AIF®