Inflation: What It Is, Where It Comes From And How To Protect Your Portfolio From It

The U.S. economy is firing on all cylinders, which is generally good news for investors. Yet a booming economy also creates its own set of unique financial problems — and inflation is at the top of the list.

What Is Inflation?

The U.S. unemployment rate is at its lowest level in four decades at 3.7 percent. While that low unemployment rate is great news for American workers, it’s not necessarily great news for U.S. companies looking to grow their businesses. These companies are now competing to hire a dwindling number of qualified employees, and the increasing competition for labor eventually leads to companies being forced to raise wages.

While rising wages are good for workers, increasing labor costs eat into corporate profits, making it harder to grow earnings. To compensate, companies in a booming economy tend to pass those costs on to their customers by raising prices. As a result, the purchasing power of a dollar decreases over time.

Why Do Investors Care?

For an investor, inflation is a constant enemy. Back in 1940, $3,000 was sufficient to buy a nice house in the U.S. But if someone had buried that $3,000 in their backyard in 1940 and dug it up in 2018, $3,000 today would barely be enough to buy a beat-up used car.

Inflation puts constant pressure on investors to generate positive returns just to maintain their purchasing power. The Federal Reserve is tasked with managing inflation rates by raising or lowering interest rates, and its target inflation rate is 2 percent. In August, the U.S. inflation rate was 2.7 percent, but it has approached 3 percent this year for the first time since 2011.

How To Combat Inflation

Historically, inflation has been bad news for U.S. stocks. Since the 1930s, stocks have produced annualized gains of just 1 percent during periods in which inflation rose for at least six months. The rest of the time, the market generated annualized gains of about 7 percent.

Fortunately, there are several ways for investors to combat inflation.

Treasury Inflation-Protected Securities, or TIPS, are treasury bonds that are indexed to inflation and adjusted every six months to neutralize the impact of inflation. TIPS can be purchased directly from the Treasury, or investors can buy TIPS ETFs such as the iShares Barclays TIPS Bond Fund TIP.

Commodities and real assets also tend to perform well during inflationary periods; real estate investment trusts have historically outperformed during inflationary periods. Gold and oil are also popular inflationary hedges. The VANGUARD IX FUN/RL EST IX FD ETF VNQ, the SPDR Gold Trust GLD and the United States Oil Fund LP USO are three popular ways to invest in these themes.

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