Are you adjusting your clients’ portfolios for inflation?

If you responded with, “Inflation? What inflation?” you’d be right, but also wrong.

Right, because the official U.S. inflation rate, at just 1.5%, hardly seems worth the worry. In fact, at that level, inflation could actually be dragging down the economy. Which is why the Fed has been trying—so far without much success—to raise the rate to its stated target of about 2%. Yet even if inflation does hit that target, it would be unlikely to impact most investment portfolios.

But you’d also be wrong, and for two main reasons: 1) By reducing the purchasing power of every dollar, inflation hurts retirees and other clients living off fixed-income portfolios; and 2) many financial experts now see trends emerging that could cause inflation rates to jump unexpectedly in the future.

Now that’s something to worry about, because unexpected inflation is the worst kind. Expected inflation, the kind clearly projected by the government and leading financial analysts, tends to get factored into market prices. It’s when inflation makes a surprise appearance that clients can face unpleasant losses.

Right now, advisors can expect concerns about inflation primarily from two types of clients: market skeptics who are convinced the experts are wrong and believe inflation will rise higher and faster than predicted; and retirees, especially those facing medical and other expenses that historically have risen faster than the prevailing inflation rate.

Yet some experts believe nearly all types of clients could benefit from inflation protection now. “This is a great rebalancing moment,” says Christopher Wolfe, chief investment officer of Merrill Lynch Wealth Management. “You buy fire insurance when the house isn’t on fire.”

In fact, Wolfe is advising his clients to take a three-sided view of inflation: commodities; what he calls the “slow and steady” environment, driven by policy and wages; and volatility. To protect against spikes in energy prices, he advises buying energy: “You’ve got to own the thing that’s inflating.” For slow and steady hedges, he favors real estate, especially as a long-term hold. And for volatility, Wolfe recommends instruments such as TIPS.

Taking that approach one step further is Hal Ratner, global head of research at Morningstar Investment Management. Because the inflation rate is merely an average based on a basket of consumer prices, he says, each individual investor experiences inflation differently. “If somebody’s consumption is exactly that of the Consumer Price Index, then it’s not a big issue,” he explains. “But for a person who’s retired or facing medical expenses, the CPI isn’t necessarily such a great measure.”

How to help these clients? Ratner recommends paying close attention to two vital factors: a client’s time horizon and his appetite for risk. These two factors often work hand in hand. For instance, a buy-and-hold strategy combines a long time horizon with a low level of risk. “In the long run, all asset classes keep up with inflation and do better than inflation,” Ratner says.

TIPS provide a good example. These bonds are benchmarked to the CPI, meaning their principal is adjusted to increase with inflation or decrease with deflation. For this reason, assuming some inflation, holding a TIP bond to maturity is a long-term, relatively low-risk plan. Most investors, however, are more concerned about inflation in the near term and may view TIPS as a short-term investment. But Ratner warns that the bond values can move “massively” down as well as up, so if your investment horizon is shorter term, TIPS may not be for you.

Another key to protecting clients against unexpected inflation, some experts say, is balancing a portfolio by going long on investments that typically rise with inflation and going short on those likely to fall. “People make the mistake of looking only for something that will benefit from inflation,” says Jack Rivkin, managing director and chief investment officer at alternative-investment firm Altegris. “They have to look for what is not going to benefit, too.”

Notes Rivkin, the investment category that typically is hurt the most by inflation is traditional bonds. Among those that fare the best are stocks and real estate.

Given that unexpected inflation is the real enemy, what’s the best way to see it coming? Several experts recommend monitoring statistics around employment and wages. Wages, unlike other, more volatile measures, tend to become what Dorothy Weaver, CEO and co-founder of Collins Capital, calls “embedded.” That is, once wages rise, it’s very rare for them to fall. Weaver, who is also a former chair of the Federal Reserve Bank in Miami, notes that when wages rise sufficiently, so do consumer confidence, spending and prices. Add them together and—voila!—you have inflation.

On the other hand, unemployment tends to act as an inflation buffer, making it another valuable stat to follow. When jobs are scarce, workers will accept lower-paying jobs than they would during good times. “In 2009 there were six unemployed workers in the U.S. for every job opening, and now there are three, so that’s progress,” Weaver says. “But it still means you’re not going to have a lot of inflationary wage pressure. As long as you’ve got three unemployed workers who want every job that’s available, it’s going to keep wage pressure down.”

Other stats to watch include job changes and job openings. A rise in either measure can be a precursor to a rising inflation rate. “People quit jobs because they’re taking other jobs that pay better,” Rivkin says. “If job openings rise, that means businesses are having trouble filling positions. One way to solve that problem is to offer a higher wage.”

Looking for a clearer signal? Try the yield on 30-year U.S. Treasury bonds. It’s the inflation bellwether of choice for Greg Ghodsi, managing director of Raymond James’ 360 Wealth Management Group. Since he believes that returns for virtually all asset classes reflect the yield on the 30-year T-bill, Ghodsi seeks to provide his clients with an inflation buffer by targeting their portfolios at 2.5% above the current rate—close to 4% at present.

To achieve the 6% to 6.5% return that his clients need, Ghodsi combines relatively low-yielding but very secure investments with riskier but much higher-yielding instruments. At present, he’s using low-risk, large-cap dividend-paying stocks that throw off 3% a year combined with a selective group of high-risk “flyers” that have the potential to return 20 or more.

“In this low-interest market, we want to manage the whole net worth, hitting the target while keeping overall risk as low as possible,” he says. And if interest rates creep higher? Then, Ghodsi says, “We’ll need to change our entire structure for how we manage portfolios. Nothing stays the same forever.”

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