In the last few months I’ve received numerous questions about what to do with your portfolio if you expect inflation to shoot upward in the near to intermediate future.
Is High Inflation in Our Future?
Despite all the press inflation has received recently, the market’s expectation for inflation appears to be rather modest.
The difference between yields on TIPS and nominal Treasury bonds of a given maturity is a good estimate of the market’s expectation for inflation over that period. Based on current yields of nominals and TIPS maturing in early 2021, the market appears to expect inflation of approximately 2.6% per year over the next decade. Not zero, but not exactly off the charts either.
But What if the Market is Wrong?
Of course, it’s always possible that the market will turn out to be wrong. Inflation could end up being significantly higher or lower than the market’s prediction.
Whether or not it makes sense for you to do anything to prepare for a high-inflation scenario depends on how exposed you are to inflation risk:
- If you’re entirely dependent upon your investments for income, you’re more exposed to inflation risk than somebody who is still working (or who could easily go back to work).
- If you rent, you’re more exposed to inflation risk than somebody who owns his/her home.
- If a significant amount of your retirement income is made up of a pension (or income annuity) without inflation adjustments, you’re more exposed to inflation risk.
If you find that you’re exposed to a great deal of inflation risk and you want to do something to protect yourself, any of the following might be prudent:
- Shorten the maturity on your nominal bond holdings. If inflation spikes upward, short-term bonds would be less affected than long-term bonds.
- Move more of your bond holdings into TIPS.
- Don’t prepay your mortgage. Having a low, fixed-rate mortgage during a period of high inflation would mean that you’re borrowing money at a very low–or even negative–after-inflation interest rate.
- Consider allocating a small portion of your portfolio to commodities. (Per Larry Swedroe’s excellent Guide to Alternative Investments, collateralized commodity futures–CCFs–would be my preferred means of achieving a commodity allocation, were I to desire one.)
Three Final Thoughts
If somebody tries to tell you that TIPS offer little protection against inflation because the government’s measure of inflation does not include food or energy, do not listen. While the “core inflation” figure published by the Bureau of Labor Statistics does indeed exclude food and energy prices, CPI-U (the figure upon which TIPS adjustments are based) does include both food and energy.
While stocks can be expected to outpace inflation over the long haul, they are not a very good hedge against sudden unexpected inflation, because you cannot count on them to conveniently shoot upward in price when inflation strikes.
If I had to place a bet on either the market’s expectation (modest inflation) or the mainstream financial media’s expectation (high inflation), I think you know where my money would be. The market isn’t always right, but I don’t often like to bet against it.
Hi. I'm Mike Piper, the author of this blog. I'm 
One thing I don’t see in your comments is the potential fear that the debt ceiling won’t be renewed or raised by Congress, with the result that the country may default on its debts. I personally don’t think this likely, but it can’t be overlooked that the possibility of a government shut-down the other week was welcomed with cheers by a segment of the incoming Tea Party-influenced Republican freshmen. We’ve always taken it for granted that US treasuries would not be subject to credit risk, but at this point the possibility of US credit risk is no longer inconceivable.
As for commodities, is it possible to add these to a Vanguard tax-deferred account?
Hi Larry.
If you have a VBS account (Vanguard Brokerage Services, as opposed to a Vanguard mutual fund account), you could pick an appropriate ETF. For example, Swedroe mentions GSG in his book as a decent choice.
You didn’t say a word about gold (or any other precious metals, or similar commodities.) Is that because you think they’re not a worthy inflation hedge?
Hi Greg.
It’s not because I don’t think gold can be a reasonable choice. Rather, it’s because I’d prefer to use an investment vehicle that’s diversified among various commodities.
Isn’t there a bit of conflict when you invest in TIPS? The same entity that has to cut you a check if inflation is high is the one that gets to ‘measure’ inflation.
Lance, yes, many people have that concern. IMO, it’s worth pointing out at least that they’re completely different parts of the federal government.
To date at least, CPI has done a pretty good job of measuring inflation. Though it’s always possible that could change in the future.
What’s your opinion on the S&P’s downgrading the long-term outlook on US debt?
Larry,
It’s certainly not a comforting thing. (Nor is it a surprise though, I suppose.) Of course, the downgrading itself isn’t nearly as important as the reasons behind it.
For me, I’m not changing my portfolio at all. But Treasury bonds only make up 10% of it, so it’s just not that big of a deal.
For other investors, it could mean that my previously-mentioned preference for a Treasury fund rather than a Total Bond fund is a mistake. I really don’t know.
I suppose the two most relevant questions are:
1) How likely is an actual default (and therefore how much of an allocation can one safely to devote to Treasury bonds)? and
2) Is this likely to increase the correlation that Treasury bonds have to stocks? (That is, has their usefulness as a diversifier changed?)
My guess is that the answer to #2 is “no.” Question #1, however, seems more potentially worrying. Such predictions are well beyond my realm of expertise.
It’s hard to tell right now what is really going on with all these political agendas being shoved down our throats. Hopefully we get some clear data on where inflation is going.