Inflation and our Merriman bond portfolio

Here’s an article we recently mailed to Merriman clients, addressing some inflation questions that we felt our FundAdvice readers may also be interested in:

Some investors are concerned about the prospect of future inflation, based on fiscal and monetary measures the U.S. government has taken to respond to the recent market crisis. However, other metrics suggest that moderate inflation will continue. These include current inflation, bond market indicators and worldwide excess capacity.

Merriman’s recommended bond portfolio is structured to provide a reasonable level of protection against inflation.

The Fed’s view

The Federal Reserve, in a statement on April 28th said, “With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.”

Notwithstanding this reassuring if somewhat abstruse statement, there is considerable debate about whether higher inflation will result from the fiscal and monetary actions the federal government used to curtail the market plunge from October 2007 to March 2009. Inflation is the nemesis of bond investors. An increase in inflation will cause an increase in interest rates and decrease the value of bonds. Conversely, if interest rates were to fall because of lower inflation, bond prices would rise.

What factors impact inflation and how is our bond portfolio structured to handle inflation risk?

Consumer Price Inflation

Increasing inflation can be caused by a variety of factors.

Increase in demand due to higher private or government spending causes demand-pull inflation. Government spending has ballooned, to combat the deep recession. In fact, the federal deficit as a percent of nominal GDP, at -9.9 percent as of 4/30/2010, is the worst it has been since the depths of World War II. This could lead to higher inflation down the road.

An increase in the money supply (too much money chasing too few goods) causes monetary inflation. The Federal Reserve has greatly expanded the amount of money in the system to help combat the recent crisis, and this could also lead to higher inflation.

Other types of inflation include cost-push inflation, caused by a large and sudden increase in the price of significant goods and services, such as the price of oil, and increasing inflationary expectations, where sellers increase prices and workers demand higher wages based on expectations of higher inflation.

Will the large increase in government spending combined with the Federal Reserve’s flooding the system with liquidity cause an increase in inflation? That’s tough to say. Without trying to forecast future inflation, here are some reasons that inflation may stay under control:

• The federal government, which says it is concerned by the large deficit and debt levels, may be able to cut the deficit and debt over time to more sustainable levels.
• The Federal Reserve has been very creative in battling the huge uncertainty caused by the economic crisis by injecting liquidity into the system. It may prove just as competent in withdrawing liquidity from the economy to prevent higher inflation.
• The U.S. unemployment rate is currently at 9.9 percent, compared with 4.7 percent in October 2007. High unemployment is generally associated with lower inflation.
• The industrial capacity utilization rate in the United States is currently 73.7 percent, about 7 percentage points below the average from 1972-2009. Higher inflation is more likely when industry is running near capacity, not when there is excess, unused capacity.
• The increasing production of low-cost goods in China and other developing countries has led to lower prices for U.S. consumers, and this should help limit inflation.
• The increasing use of the Internet has allowed consumers to efficiently search for the lowest-priced goods, which could also help keep prices in check.

It is difficult to forecast future economic factors and their impact on inflation. Instead of trying to forecast future inflation on our own, let’s see what current inflation is, as well as the market consensus for inflation, using both surveys and the bond market.

The 12-month change in Consumer Price Index (CPI) through April 2010 was 2.2 percent.

The Livingston Survey is the oldest continuous survey of economists’ expectations, currently averaging the outlooks of 39 forecasters. The most recent survey, in December 2009, shows that the average expectation for CPI over the next 10 years was 2.4 percent, down from 2.5 percent from the June 2009 survey.

Another way to measure the market’s expectations for inflation is to compare the yields of regular Treasuries and Treasury Inflation Protected Securities (TIPS). TIPS are Treasuries where the principal and interest payments increase with the increase in CPI. The investing public would generally only buy TIPS if they thought they would get at least the same total return as regular Treasuries. Yet the yield on TIPS is lower than that of regular Treasuries. The difference in yield is an indicator of the market’s inflation expectation.

Ten-year Treasuries currently yield 3.29 percent. Ten year TIPS yield 1.28 percent. The difference in yield is 2.01 percentage points. If inflation for the next 10 years is 2.01 percent, the TIPS holder will get the same return as an investor in regular Treasuries. If inflation is greater than 2.01 percent, TIPS will have a total return greater than regular Treasuries.

To summarize current and forecasted inflation, the 12 month increase in CPI through April was 2.2 percent. The 10 year forecast for CPI is 2.4 percent based on a survey of economists, and 2.01 percent based on TIPS.

Of course, inflation could end up being higher or lower than expectations.

Portfolio Structure

Our recommended portfolio has multiple asset classes which can help protect investors against inflation. First, as described in our article “Inflation: will your investments protect you?,” various asset classes in our recommended equity allocation, including small cap, small cap value, emerging markets and REITs, may perform well in an inflationary environment.

Second, our bond allocation is structured to provide some degree of inflation protection.

The two figures below show our recommended bond portfolio for tax-deferred and tax-managed accounts. The last column shows duration, which is a measure of interest rate sensitivity. Bonds with longer duration have greater interest rate sensitivity. For example, a bond fund with a duration of three years will have an estimated loss of 3 percent if interest rates across the board increased by 1 percent immediately. A fund with a duration of five years would have an estimated loss of 5 percent if all interest rates went up by 1 percent immediately. TIPs are indexed to inflation, but they are sensitive to changes in real interest rates (interest rates after subtracting inflation).

We do not recommend TIPs in tax-managed accounts since the increase in principal, which will not be received until maturity, is taxed each period, meaning that investors are taxed on income before they receive it.

Within the tax-deferred account, 20 percent is allocated to TIPS, where the principal and interest increase with inflation.

Another 30 percent is allocated to short-term Treasuries. In an inflationary environment, as these bonds mature, they are replaced by other bonds with presumably higher interest rates, to reflect the higher inflation rates.

Half of the bond portfolio is invested in securities which either adjust explicitly with inflation or else adjust quickly to higher interest rates.

The other half of the portfolio is in slightly longer securities, with an average duration of 4.8 years. Note that we avoid the longest bonds of 20-30 year maturity, which may be hit hardest by an overall increase in interest rates. There is a substantial pickup in yield of 2.08 percent between the Vanguard Short-Term Treasury fund (VFISX) and the DFA Intermediate Government Fixed Income fund (DFIGX), going from 1.1 percent to 3.18 percent. This is due to the somewhat longer maturities in the DFA fund, and the fact that the DFA fund invests in both U.S. Treasuries and U.S. agency and other securities with AAA ratings.

Inflation Increases

What if inflation increases, from the current 2.2 percent to 3.2 percent? First, a little more inflation will likely raise home prices, which could improve people’s confidence and the overall economy. Also, if higher inflation is caused by a pickup in hiring, consumption and stocks could benefit.

What would happen to the performance of DFIGX, relative to VFISX, if inflation increased from 2.2 percent to 3.2 percent? On a total rate of return basis, the higher yield of DFIGX would help offset the lower prices caused by higher interest rates. Assuming all interest rates increased by 1 percent immediately, DFIGX would lose around 4.8 percent in its principal value, versus an estimated loss of 2.1 percent on VFISX, a difference of 2.7 percentage points. Over the course of one year, DFIGX would generate 2.1 percent more in income. So, over one year, DFIGX would underperform by an estimated 0.6 percent, if interest rates rose by 1 percent immediately, which is very unlikely.

For an investor, in a 60 percent equity/40 percent bond portfolio where DFIGX was 20 percent of the total, this underperformance from DFIGX would decrease the portfolio’s return by only 0.12 percent.

Deflation

In many ways, deflation is worse than moderate inflation. If consumers thought that prices would be lower in the future, they would not buy things today. Companies would also postpone purchases and investment. This delayed consumption and investment could cost jobs and hurt stock prices.

While bond prices are hurt by inflation, they are helped by deflation. If interest rates decrease with deflation, it helps the longer bonds the most. In this instance, DFIGX could be the best performing fund in the bond portfolio.

Final Thoughts

There are certainly reasons to be worried about potential future increases in inflation. There are other forces, including a hopefully vigilant Federal Reserve, excess capacity, and global competition, which could help keep inflation at more moderate levels.

We do not know what future inflation will be. What we can do is calmly and comprehensively think about the potential impact of various scenarios in advance, and then construct an overall portfolio which we believe will perform satisfactorily under different economic environments.