One of the world’s most successful bond managers is encouraging investors to bet against predictions made recently by Federal Reserve Chairman Ben Bernanke, who recently told a group of business leaders that inflation was not a major concern and could even move lower from its current levels.
Bill Tedford, who manages a bond portfolio for Stephens Inc., believes that inflation is already evident and that the consumer price index (CPI) will surge over the next two years. Tedford is among the growing number of “inflation bugs” who believe that the massive injections of cash into the economy will ultimately result in a big uptick in inflation. Stephens has begun encouraging clients to move money into oil, timber, agriculture, and precious and industrial metals to protect against inflation.
Tedford’s expectations focus on the domestic monetary base, essentially the money circulating among the public or reserve banks on deposit with the Federal Reserve. Noting that over the long term inflation tends to track increases in the monetary base that exceed economic expansion, he believes the stage is set for a surge in CPI. “In the wake of the U.S.-inspired global financial crisis, the nation’s monetary base has ballooned to more than $2 trillion at the end of November from less than $850 million in August 2008, before the crisis began, according to Federal Reserve data,” writes Jeff Opdyke. “Even subtracting the more than $1 trillion in excess reserves, the nation’s monetary base has grown by more than 11% in the past 15 months.” During that same period, GDP contracted by about 2%, meaning the gap between the two data points is nearly 13%.
Tedford isn’t alone in his beliefs. Billionaire hedge fund manager John Paulson is another inflation bug, and has begun betting on gold. And earlier this year the team behind the now legendary Black Swan Fund launched a new fund focusing on delivering big gains if hyperinflation sets in. But others are not so sure a big jump in inflation is imminent, noting that a number of other factors come into play as well and that an increase in the money base can take a long time to translate into an uptick in prices.
ETF Plays On Inflation
While Tedford has begun shorting 30-Year Treasuries in his own portfolio, his firm in encouraging the use of ETFs to establish an inflation hedge in their portfolios. The exchange-traded products Stephens likes include:
- United States Gasoline Fund (UGA): This fund seeks to offer exposure to gasoline prices by investing in futures contracts on unleaded gasoline traded on the NYMEX. Similar to UNG, this fund invests primarily in near-month futures contracts, rolling holdings over when the expiration date approaches. Unlike UNG, however, UGA accounts for a relatively small portion of the gasoline futures market, minimizing the impact its sales have on market prices.
- iShares Dow Jones U.S. Oil & Gas Exploration & Production Index (IEO): This ETF is designed to measure the performance of the oil exploration and production sub-sector of the U.S. equity market, and invests in companies that are engaged in the exploration for and extraction, production, refining, and supply of oil and gas products.
- SPDR Gold Trust (GLD): The most popular option for investors looking to gain exposure to gold prices, GLD stores gold bullion in secure vaults. For a look at GLD and alternative gold ETFs, see this complete guide.
- PowerShares DB Base Metals Fund (DBB): This fund tracks a rules-based index composed of futures contracts on some of the most liquid and widely-used base metals, including aluminum, zinc, and grade A copper. Each of these three metals is given a base weighting of 33.3% in DBB, although these allocations may change over time as prices fluctuate.
- PowerShares DB Agriculture Fund (DBA): This ETF is based on an index composed of futures contracts on a variety of agricultural commodities. As of December 24, DBA included allocations to cattle, cocoa, coffee, corn, cotton, lean hogs, soybeans, sugar, and wheat. Because food prices are often among the first to rise in hyperinflationary environments, investments in agriculture are often seen as an effective inflation hedge.
Conspicuously absent from Tedford’s ETF list in the iShares Barclays TIPS Bond Fund (TIP), which invests in inflation-protected securities issued by the U.S. government. While this would seem like an obvious play for investors expecting inflation to take off, Stephens actually just sold its holdings. Real yields are around 1% at present, and the group expects yields to rise as inflation rises, sending prices in the opposite direction. “The return on your TIPS could fall 10% or 15%,” says Tedford.
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Disclosure: No positions at time of writing.