DWS Investments: Commodities, ‘Floating-Rate’ Loans Historically Offer Inflation Protection

DWS Investments: Commodities, ‘Floating-Rate’ Loans Historically Offer Inflation Protection
09 March 2011, 3:20 p.m.
By Allen Sykora
Of Kitco News 

(Kitco News) - Consumer-price inflation is likely to trend higher, and history suggests that investment through commodities and “floating-rate” loans has tended to fare best at such times, said the chief mutual-fund strategist with DWS Investments on Wednesday.

“We think both of those are best suited for this environment to protect clients against inflation going forward,” said Mark Peterson, head of mutual-fund strategy with DWS Investments, the U.S. retail unit of Deutsche Bank’s Asset Management division.

He spoke with financial journalists via a teleconference about inflation data past and present, as well as investment strategies investors and advisors can use to safeguard portfolios.

Peterson cautioned that “it’s a little bit tricky” to gauge various asset classes in times of sharply high inflation, since this has not occurred since the late 1970s and early 1980s. Some asset classes, such as Treasury Inflation-Protected Securities (TIPS), were not in existence then.

Based on correlation studies, “floating rates” moved the most with inflation, he said. The category includes below-investment-grade loans to corporations. Investors can pick from some 30 to 35 mutual funds in this category, less than 1% of all mutual funds, although the category may well grow, he said.

“It does well when inflation rises. It also does well when interest rates rise, because one main feature of these loans is they actually adjust their interest rate as interest rates go up,” Peterson said.

The commodities category was the second-best performer in inflation-correlation studies, Peterson said. In the 1970s, investors in this arena sometimes got annual returns of more than 20%.

Peterson suggested there is still upside potential in commodities even though they have already run much higher in price.

“When you look back historically, commodity cycles and outperformances lasted for long periods of time,” he said. “If we look back at the last two cycles, the average cycle of commodity outperformance is about 18 years. We’re maybe 10 years into that cycle. So we think we’re in the middle innings of that commodity outperformance.”

Upward cycles in commodities tend to last because it often takes considerable time to “fix” supply/demand imbalances, particularly in the case of natural-resource extraction, Peterson said.

For a commodity such as corn, high prices might prompt producers to significantly increase their production the following year, thus alleviating shortages.

“You certainly don’t have that same dynamic with oil, gold and some of the harder-to-extract commodities,” Peterson said. (Mining analysts frequently tell Kitco News that it can take years to open a new mine, due to the time needed to measure mineral quantities in ore bodies, obtain permits and financing, then construct the mines.)

Investment that focuses on either direct commodity price exposure, or commodity-related equities, currently amounts to less than 2.5% of all mutual-fund assets, Peterson said.

“So we think this has a ways to go too,” he said. “We think folks are a little bit behind the curve here. We think commodities (are) a great solution.”

He did not rate the different sectors within the commodity arena.

“Just getting a broad-based exposure makes the most sense for most of our clientele,” he said. “As we all know, those categories can be extremely volatile.”

Meanwhile, Peterson described TIPS as a better fixed-income asset during inflation than some of the traditional bond classes. Still, he described the correlation between TIPS and inflation as “not tremendously impressive.”

While it’s hard for economists to pinpoint the precise timing on when consumer-price inflation may surge, Deutsche Bank believes trend will be higher, Peterson said. In particular, the significant category of rent is expected to rise.

Furthermore, Peterson pointed out that many investors feel official government data may understate actual inflation, particularly due to some of the changes made over the years to some of the categories that make up the Consumer Price Index.

Presently, Peterson said, the bank estimates only 17% of investor dollars are allocated into categories that will benefit from higher inflation. “If you haven’t had inflation as an issue over the last 30 years, you can see why folks have not invested there,” he said.

By contrast, more than 30% of mutual or money funds are allocated into categories that can benefit from deflation, he said. Thus, he said, investors may want to start exploring how they can protect their portfolios from inflation.

Over the last year, Peterson said, seven of the 10 items in the CPI that rose most in price are “basic needs” such as food and energy, led by butter, up nearly 22% year on year. Meanwhile, he said, the CPI data shows certain technology and luxury items have declined in price.