THE FIDUCIARY FOCUS
Guard Against Inflation Revisited
Preserving the Purchasing Power of Your Assets
Monetary policy in the United States took a dramatic turn
with the introduction of quantitative easing. The strategy, in
response to the financial crisis of 2008, consists of purchasing
outstanding debt in the marketplace by the Federal Reserve. It
has increased the balance sheet of the Fed to more than $3.5
trillion dollars.
Figure 1: Value of $1 From 1992–2012
Although quantitative easing has achieved its primary
objective by forcing down long-term interest rates, it has
also increased the supply of money in the economy, which
has contributed to inflationary pressures in the past. While
we have been fortunate to have seen a lengthy and very low
inflationary environment, as money supply increases, the
probability of higher inflation also increases.
What is inflation?
Inflation is a general increase in prices and a corresponding
fall in the purchasing power of money, while deflation is a
decrease in prices and a corresponding rise in purchasing
power. There are several methods to measure inflation, with
the U.S. Consumer Price Index (CPI) being the most common.
the current environment, low inflation can rapidly decrease
purchasing power of an investment portfolio. For example, as
seen in Figure 1, during the 1992-2012 period, when CPI was
well below the 50-year average, $1 in 1992 would be worth
less than $0.59 by the end of 2012.
CPI is a measure of the price changes in over 200 goods
and services that an “average” American consumes. Though
CPI is certainly the most common inflation measure used
by investors, other measures are available. For example, the
Fed uses the Personal Consumption Expenditures (PCE)
index when targeting an inflation level. Additionally, several
universities make use of the Higher Education Price Index
(HEPI), which serves as an overall measure of inflation
affecting the higher education sector. From 1992 through
2012, inflation as defined by CPI has averaged 2.5% while
PCE and HEPI averaged 2.0% and 3.3% respectively. All
measures currently are significantly lower than their 50-year
averages, which are 4.2% for CPI, 3.6% for PCE and 5.0%
for HEPI.
During periods of low inflation, a portfolio that is not properly
protected from the destructive properties of inflation will see
purchasing power erode. As a result, organizations should
be aware of the threat that inflation presents at all times and
take appropriate steps to protect their investment portfolios
throughout all market cycles. One of the most efficient
ways to approach this issue is to make a long-term strategic
allocation to assets that typically benefit from inflation. This
includes investment in liquid assets, such as commodities, real
estate investment trusts (REITs) and the Treasury’s inflationprotected securities (TIPS).
Impact on Invested Assets
Nonprofit investors, including endowments and foundations,
generally seek to maximize spending as they minimize
the volatility of distributions. In order to promote
intergenerational equity, nonprofits should also seek to grow
principal in inflation-adjusted terms. By growing principal,
an organization is able to ensure future generations are able
to benefit equally from the investment portfolio. Growth of
principal in inflation-adjusted terms also is necessary for an
organization to continue its mission in perpetuity. Even in
Protecting Against Inflation
Commodities
Commodities are tangible assets that historically have
performed well in a high inflationary environment.
Commodities can be divided into five main categories which
include: energy (oil, natural gas), industrial metals (copper,
aluminum, nickel), precious metals (silver, gold), agriculture
(corn, soybeans, wheat), and livestock (cattle, hogs).
Commodities usually perform well in a high inflation
environment because many are included in the inflation
calculation. For example, food and gasoline make up roughly
25% of the CPI calculation. Therefore, a rise in food and
energy commodities would also lead to an increase in the
CPI measure of inflation, assuming all other factors are held
constant.
For the same reason that commodities perform well in periods
of high inflation, they also perform poorly during periods of
low inflation. From the period January 1980 through June
2013, a broad basket of commodities, as measured by the
Goldman Sachs Commodity Index (GSCI), produced an
average annualized return of 11.61% during high inflation
periods versus an average annualized return of -9.38% in
low inflation periods.1 Gold has historically been viewed
as the asset of choice during high inflation environments.
Interestingly, gold has produced a 6% long-term average
annual return during high inflationary environments, showing
that the asset is not affected as much by inflation as many
investors are led to believe.
REITs
Real estate investment trusts are companies that act as
investment agents who specialize in income-producing real
estate and real estate mortgages. There are three distinctive
types of REITs: equity REITs, mortgage REITs and hybrid
REITs. Equity REITs are companies that own and manage
income-producing properties while mortgage REITs invest
in mortgages secured by real estate. Hybrid REITs are a
combination of the two. Equity REITs are divided into
additional categories, with the most prominent being industrial/
office, retail, residential, diversified, lodging/resorts, health
care and self-storage. It is important to note that REITs do not
invest in single-family homes or other types of privately held
real estate, as these properties tend not to produce consistent
income. Regardless of type, REITs are required by law to
pay out at least 90% of their taxable income in the form of
dividends. This leads to many REITs having attractive yields,
especially when compared to the broad U.S. equity market.
For purposes of protecting against inflation, equity REITs
have considerable benefits to offer investors. Companies that
own income producing real estate have the opportunity to
raise rents during periods of rising inflation. This benefit is
passed on to the REIT investor in the form of higher income
during high inflationary environments, a characteristic not
found in mortgages where the rate has likely been fixed. This
is evident in the performance of equity and mortgage REITs
during high inflation environments.2 From 1974 through May
2013, equity REITs generated a return in excess of inflation
71% of the time, compared to only 48% of the time for
mortgage REITs.
TIPS
The Treasury’s inflation-protected securities (TIPS) are bonds
issued by the Treasury Department and backed by the U.S.
government. TIPS are very similar to nominal or “normal”
U.S. Treasury securities, but have the added benefit of interest
payments that adjust to changes in the U.S. inflation rate. Like
all bonds, prices can fluctuate due to changes in interest rates.
However, the principal value of TIPS increases with inflation
and decreases with deflation. Additionally, the security pays
interest two times a year at a given rate. This rate is calculated
using the inflation-adjusted principal amount, so interest
Figure 2: TIPS–Hypothetical Interest Payments
Five-Year TIPS
Issuance
Year 1
Year 2
Year 3
Year 4
Year 5
Principal Payment
Annual
CPI
–
1.0%
2.5%
-1.15%
-5.0%
6.5%
Principal
Amount
$1,000
$1,010
$1,035
$1,020
$ 969
$1,032
Principal
Coupon
2.0%
2.0%
2.0%
2.0%
2.0%
2.0%
Interest
Payment
–
$20.20
$20.71
$20.39
$19.37
$20.63
–
$1,032
–
–
payments will also increase with inflation and decrease with
deflation. For example, a TIP security has a principal value
of $1,000 and pays an interest rate (coupon) of 3%. Six
months after the issuance of this bond, inflation has risen
2%. The principal is then adjusted to keep pace with inflation
(increased 2%) and is now valued at $1,020. The interest
payment is calculated using this new principal amount. With
TIPS, instead of receiving 1.5% (half of the 3% annual rate,
because it only has been six months) of $1,000, the investor
receives 1.5% of $1,020. As an added bonus, at the maturity
of the bond the investor can receive no less than the original
principal (in this example, $1,000) regardless of the extent
of deflation. These features allow the investor to maintain
purchasing power regardless of the inflationary environment.
A more detailed example of how TIPS payments react in an
inflationary environment can be seen in Figure 2.
Despite running at below-average levels for 20 years, inflation
continues to harm nonprofit portfolios and slowly erode
purchasing power. Organizations can help preserve purchasing
power by maintaining a long-term allocation to assets that
protect from inflation, such as commodities, REITS, and TIPS.
Akin to buying homeowners insurance before a house fire
starts, the value of owning an inflation hedge is greatest before
the price of the hedge goes up, that is, before an increase in the
inflation rate.
1 Using the Fed definition of high inflation as 2% PCE, which historically equates to
about 2.5% CPI.
2 Defined as exceeding the Fed target inflation rate of 2.5% CPI.
William M. Courson is the president of
Lancaster Pollard Investment Advisory Group
in Columbus. He may be reached at wcourson@
lancasterpollard.com.
This publication has been prepared by Lancaster Pollard Investment Advisory Group.
It is for informational purposes and is not an offer to buy or sell or a solicitation of an
offer to buy or sell any security or instrument or to participate in any particular investment
strategy. The information provided is not intended to be a complete analysis of every
material fact respecting any strategy and has been presented for educational purposes
only. Please contact your investment consultant to discuss your organization’s situation.
The information herein has been obtained from sources believed to be accurate and
reliable; however, we do not guarantee the accuracy, adequacy or completeness of any
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change without notice. Any return expectations provided are not intended as, and must not
be regarded as, a representation, warranty or prediction that the investment will achieve
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losses. There are risks involved with investing, including possible loss of principal.