ETFs For Inflation - Or Deflation

Which will it be: Inflation or deflation? And what can you do to protect yourself in either scenario?

My answer to the first question is BOTH! I think we’ll see waves of inflation as well as periods of deflation in the next decade. The bigger question is the timing.

For now, deflation seems to have the upper hand. Figures released by the government last week showed the Consumer Price Index (CPI) fell 2.1 percent in the last year. That was the biggest drop since 1950.

On the other hand, with the folks in Washington spending like crazy and the Treasury Department cranking up its printing presses, it’s hard to see how we’ll avoid a serious bout with inflation before too long.

I’m not here to give you an economic forecast. Instead, I want to show you how to use exchange-traded funds (ETFs) to survive and profit … no matter what happens!

Of course, with hundreds of ETFs now available there are many, many alternatives. To keep it simple, I’ll give you three ETFs that I think will do well when inflation hits, and three that are better for deflationary times.

Inflation ETF #1: GLD

Nothing beats inflation like gold. The reason is simple: Gold is real money, not just paper backed by a political promise.

GLD is like having gold in the bank.

There are practical problems with gold, though. You can only store so much of it under your mattress. And gold can be hard to trade for anything else unless you go through a dealer, pawn shop, etc.

The SPDR Gold Trust (GLD) is a good proxy for gold. I wrote about this ETF in my May 28 column. Each share of GLD represents 1/10 of an ounce of gold, stored in secured London vaults for you. You can buy and sell the shares instantly online just like any other stock or ETF.

Inflation ETF #2: TIP

You might think bonds are boring - and sometimes they are. On the other hand, if other assets are getting crushed, “boring” may be just what you need!

When inflation strikes, most types of bonds are the last thing you want to own. However, one type of bond is custom-made to thrive during inflation: Treasury Inflation-Protected Securities (TIPS). These are U.S. Treasury bonds in which the price automatically goes up as the CPI rises. The yield on these special bonds can be thought of as the “after inflation” yield.

Buying TIPS in small quantities can be tough … fees can be high, plus you won’t get much diversification in maturity dates.

But there’s a great ETF that does the heavy lifting for you …

The iShares Barclays TIPS Bond Fund (TIP) is nothing more than an indexed portfolio of inflation-protected bonds, which makes it a great place to stash some money you want to keep safe from inflation.

Inflation ETF #3: IXC

Last year we got a hint of what real inflation looks like when crude oil surged to $150. We may see that level again, or even higher, if inflation grips the world economy.

In an inflationary era, energy producers darn near have a license to print money. That means whether they own oil reserves in the ground or are involved in exploration and production, energy stocks are a great inflation hedge.

You can take your pick from many ETFs covering the energy sector. I particularly like the iShares S&P Global Energy Sector Index Fund (IXC).

IXC covers the worldwide energy sector.

Unlike most of its peers, IXC includes non-U.S. companies in its portfolio. This is especially important because some big players like BP, Total and Royal Dutch Shell are domiciled in other countries. Yet many energy sector ETFs completely ignore these companies!

Now, let’s take a look at some ETFs that can do well during deflation …

Deflation ETF #1: TLT

Just as most bond ETFs (except for TIP) tend to suffer during inflation, bonds are one of the best assets to own when deflation comes knocking at your door. Prevailing interest rates tend to grind lower and lower, giving bondholders capital gains as well as a current yield.

In this scenario, longer-term bonds will do better than the short maturities. And a great way to own these bonds is with the iShares Barclays 20+ Year Treasury Bond Fund (TLT). With TLT, you get a diversified portfolio of the longest-term U.S. Treasury securities.

Fees in TLT are minimal - only 0.15 percent annually - though you’ll have to pay a brokerage commission to buy and sell. TLT can have some big swings as interest rates fluctuate, so don’t be surprised at the volatility. If we get a deflationary spiral, you’ll be glad to own this excellent ETF.

Deflation ETF #2: UDN

How will the U.S. dollar perform when deflation strikes? I’m not sure anyone really knows. We haven’t seen many examples since the modern exchange rate regimes were put in place after World War II.

However, currency values are always relative …

If all currencies are losing purchasing power, but one loses less than the others, you can expect that currency to outperform. That doesn’t make it a “strong” currency. It just means one currency is not as weak as the others.

In a worldwide deflation, world trade will shrink and foreigners will have less incentive to hold the greenback. This should make the dollar lose value against other currencies.

UDN can profit as foreign currencies rise against the U.S. dollar.

A good way to bet on a falling dollar is with the PowerShares DB U.S. Dollar Bearish (UDN). This ETF is designed to replicate the performance of a short position in the dollar against a basket of other currencies.

Deflation ETF #3: SH

If deflation takes control, the business environment will get even tougher than it is now. Plagued with overcapacity and falling sales, turning a profit will be hard for even the best-run companies.

The stock market can handle a small amount of inflation and tends to enjoy disinflation, but outright deflation will crush the major benchmarks. It might be possible to make money in a few well-chosen stocks and sectors. But for the most part, stocks will be very, very weak.

Fortunately, with inverse ETFs you can take advantage of a falling market. My pick is the ProShares Short S&P 500 (SH). This ETF is designed to deliver the inverse daily performance of the S&P 500 index (^GSPC).

Unlike some of the more popular inverse ETFs, SH is not leveraged. That’s one reason I like it. I’d rather not get too aggressive in uncertain times, and the leveraged inverse ETFs are subject to huge swings in both directions.

As you’ve seen, ETFs offer you ways to profit whether we get inflation, deflation, or both. So there’s no reason to sit on the sidelines when you could be making a nice gain.

To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive.

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Comment by Ken Faulkenberry

2009-09-06 21:39:41

Ron
This is a excellent informative article. My only arguement with you would be the UUP ETF would be approriate for deflation. The dollar has been strong during periods of deflaton and disinflation. If you interested I have a article titled “The Great Tug of War: Deflation or Inflation” located at: http://www.blog.ArborInvestmentPlanner.com/?p=41
Thanks you.

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