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Why inflation remains a threat – and what to do about it

Inflation may be fading, but it's far from tamed – and investors need to safeguard their portfolios against this serious threat to longer-term returns, one of the world's biggest bond investors says.

"We expect global inflation over the next three to five years – or even the next five to 10 years – to be higher than it has been over the last 20 years. While we do not expect double-digit inflation, we do see inflation gradually climbing higher than the close to 2-per-cent core numbers that we have gotten used to in much of the developed world," said portfolio manager Mihir Worah, head of real-return portfolio management at Pacific Investment Management Co. LLC, the bond-investing giant cofounded by famed money manager Bill Gross.

"Thinking about inflation and structuring portfolios in an attempt to guard against high inflation should be a central element of any investment strategy," Mr. Worah said in an interview posted Monday on Pimco's website.

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Pimco's advice seems at odds with recent U.S. inflation trends. Last week, the U.S. government reported that the consumer price index fell 0.3 per cent in May, its biggest monthly decline in more than three years. The annual CPI inflation rate dipped to 1.7 per cent, the lowest since the beginning of 2011, and has been in decline for the past eight months. With the decline of prices for gasoline and other key commodities and with the U.S. jobs recovery stalling, the inflationary pressures on the U.S. economy seem to have eased considerably.

"Headline inflation has dropped this year in most major economies and is likely to come down further as global growth falters, the euro zone crisis deepens and commodity prices continue to fall. We expect inflation to average just 1 per cent in the G7 next year," said Capital Economics senior global economist Andrew Kenningham in a research note last week. "Headline inflation has also fallen in most emerging economies, as a result of lower food and energy price rises."

But Pimco's Mr. Worah argued that several key factors will push inflation rates upward in the coming years.

"First, in developed markets, there is a serious debt problem, and it is going to be hard for developed countries to grow out of it. Inflation is one of the only 'solutions' that we see as likely to occur," he said.

Second, he said, the maturing of many major emerging markets means they will become less of a "source of disinflation" that they have been in recent years. Their growing middle-class populations will not only push up wages that will increase the costs of previously inexpensive emerging-market manufactured exports, but will fuel a rise in demand for resource-intensive consumer goods that will drive up global commodity prices.

He recommends that investors load up on inflation-linked bonds – such as Treasury inflation-protected securities (TIPS) in the U.S. or real-return bonds in Canada – as a "core asset" to protect their long-term returns from inflation. The rate of return on these securities is adjusted for inflation, effectively removing inflation risk.

Real yields on TIPS this year have turned negative – the yield excluding inflation has been below zero – including an April auction of five-year TIPS that produced a yield of negative 1.08 per cent, the worst yield in the 15-year history of the securities. But in a recent report, Mr. Worah and colleague Jeremie Banet argued in favour of TIPS as "an opportunity for long-term investors, mainly due to market-implied inflation expectations."

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They noted that traditional U.S. government bonds are also yielding less than the inflation rate (the current yield on U.S. five-year Treasuries is about 0.7 per cent) – implying an expectation that inflation will continue to fall from already historically low levels. The more inflation rises – as Pimco predicts – the more attractive the inflation-adjusted yield on the TIPS becomes relative to the unadjusted yields of traditional bonds.

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