On guard against inflation

Warning signs of inflation have begun to appear, and while bond investors so far seem to be ignoring them, investment advisers should not. The warning signs being ignored include a Consumer Price Index rise of 2.4% for the 12 months ended January and wage inflation climbing to 2.5% at the end of 2015 from less than 2%. The CPI figures do not include volatile food and energy prices. Despite the CPI figure an-nounced on Feb. 19, the benchmark 10-year Treasury barely budged and its yield remains below 2%, a sign that investors are not concerned about inflation. Another indicator is that the inflation implied by the yield on 10-year Treasury Inflation-Protected Security is only 1.24%. Nevertheless, advisers should be paying attention and considering moves to protect their clients if this hint that inflation is not dead but only sleeping turns out to be a timely warning. Research has shown that inflation, particularly unexpected inflation, is harmful to stocks, which have done relatively poorly historically when inflation climbs much above 3% a year. In particular, stocks are not the hedge against inflation that many investors believe. In the 1970s, when inflation surged, the Standard & Poor's 500 increased only 1.6%. Including dividends the total return was 5.8%, but inflation averaged 7.4%, resulting in a real total return of -1.4%. Stocks did best in the 1980s and 1990s when inflation was declining from the peaks of the 1970s. However, research also has shown that inflation does not affect all stocks in the same way — growth stocks are hurt far more than value stocks. During the 1970s, value stocks outperformed growth stocks by 8.4%, compared with the historical average of 4.7%. This suggests that advisers can provide some protection — though not complete protection — for their clients against a surge in inflation by increasing their weighting in value stocks. They might also consider moving more assets into TIPS. It might not be time to move yet, but advisers should be monitoring the inflation indicators and preparing to advise their clients on defensive moves.