Inflation has been quiescent the last few years, and the world’s monetary authorities are convinced that, in spite of their extreme money printing, it’ll stay that way.
But we should regard all such predictions with the deepest suspicion and structure our portfolios accordingly.
Specifically, we need to see how sensitive our portfolio is to an upsurge in inflation and select some plays that may neutralize this risk.
Fortunately, there are a number of places dividend investors can look if they want their income to keep up with inflation… or even beat it.
Inflation Dead Ahead?
Most income-oriented investments do poorly in an inflationary surge. Therefore, defending against a possible inflation surge is sensible.
At the moment, Friedmanite monetarists would expect U.S. inflation to be running at a fairly substantial clip. In fact, Friedman’s theory that inflation is everywhere and is always a monetary phenomenon seems to suggest that inflation is about to accelerate.
M2 money supply has increased 5.6% in the past year, compared to a 4% increase in nominal GDP, and has been increasing faster than nominal GDP since 2009.
The decline in the U.S. unemployment rate towards the “full employment” level of 5% will likely increase wage pressures, as well. And declining oil prices will cause U.S. consumption to increase, putting further pressure on prices generally.
Another concern is that many dividend-oriented investments are derived from companies whose revenue doesn’t increase with inflation and may even be adversely affected by it.
Banks, for example, earn their money in nominal dollars and have bond portfolios that will decline in price as inflation rises. Mortgage REITs are even more dangerous in an inflationary period, because their income streams decline with short-term rate increases and their asset values decline with increases in long-term rates.
Even business investment companies, which frequently pay high dividends, are generally doing so from an income stream in nominal dollars from bonds and preferred share investments in companies.
Inflation-Proofing a Portfolio
Now, dividend investors who have their money in consumer staples companies like Procter and Gamble (PG) can sleep easy: Those companies should be able to raise revenue with inflation. Tech companies, too, are inflation-proof. The price of their products may decline, but it’ll decline more slowly in an inflationary environment while usage continues to increase.
However, not everyone is in that position. Most income investors, therefore, should consider these three options for protecting their portfolios against inflation:
1. Foreign Stocks
In the inflationary 1980s, investors did well with German and Japanese stocks. But this time around, Japanese monetary policy is even more cuckoo than the Fed’s, so Japan is no safe haven. Germany, though, is a country with a rational fear of inflation that acts as a brake on European Central Bank money printing schemes. A diversified German fund such as the iShares MSWCI Germany Fund (EWG) provides diversification away from an inflationary dollar into a better-managed economy.
Of course, EWG isn’t a wonderful income investment, with a barely tolerable yield of 2.3%. If that’s too low, you might look at the iShares MSCI Sweden Fund (EWD), which has a 3.8% yield and similar advantages. (Sweden has a soundly managed currency and is not a eurozone member.)
2. Mining Companies
Inflation tends to benefit minerals prices, and that means mining company earnings should do well in such an environment while their debt declines in real value.
Most don’t pay decent dividends, but one that does is Freeport McMoRan Inc. (FCX). Active worldwide in copper, gold, and other metals, and with a substantial U.S. oil operation, FCX boasts a current dividend yield of 4.2%. Its most recent quarter showed earnings of $552 million, and it’s trading on a P/E of 13.7 times, meaning the shares are decent value.
3. Equity Real Estate Investment Trusts (REITs)
These REITs invest in real estate, generally on a leveraged basis, thus benefiting from an inflationary burst as the real value of their debts declines while rental income increases.
One equity REIT we particularly like is Omega Healthcare Investors (OHI), which invests in healthcare properties, thus benefiting from continually rising activity in that sector. It currently yields a nice 5.5%, though about 20% of that dividend comes from cash flow rather than earnings.
My only caveat is that the shares are a little rich currently, trading at more than three times book value (but book value in real estate companies tends to understate their true value, because the properties are depreciated on the books rather than rising in value, as in real life).
Another equity REIT with a particularly juicy yield is EPR Properties (EPR), which has an especially nice 6.1% dividend yield, about 90% of which is covered by net income. EPR invests in entertainment properties in the United States and Canada, and is less richly priced than OHI at only 60% above book value.
Inflation may not look a big problem currently, but that makes it a good time to ensure that your portfolio is inflation-proof. The above suggestions should help you do just that.
Finally, before I sign off, it’s worth noting that our Chief Income Analyst, Alan Gula, has a different take on the current state of global inflation (which just hit a 59-month low). Be sure to check out his piece to see how today’s low inflation is affecting investors.