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Just as we were starting to feel confident again that the worst of the credit crunch was behind us, fear is creeping back into global markets – this time over the threat of inflation.

And investors have a reason to be fearful. Trillions of dollars have been pumped into the global economy via “stimulus packages”, and an unprecedented amount of new money has been printed. Take the US as a case in point: in the four months to December 2008, the Federal Reserve literally doubled the monetary base – the biggest injection in the Federal Reserve’s entire history since 1913.

Excessive growth in the money supply eventually leads to one thing – inflation. And although the sound of ‘inflation’ sounds hardly as menacing as a ‘Global Financial Crisis’, don’t underestimate its impact – particularly if you invest for yield. Inflation will directly reduce the returns that you make from investments such cash, term deposits, bonds and debentures – not to mention whittling away your everyday standard of living.

Over the past few years do you feel like you have more or less money after bills have been paid? Is grocery shopping getting cheaper or more expensive? Most of us are finding that the costs of living are going up, and this is the insidious effect of inflation at work. Although you might feel richer on paper your money simply doesn’t go as far as it used to.  

If inflation is indeed the storm gathering on the horizon then you need to be prepared for its impact.

The first step is accepting the fact that inflation eats into the value of money, thereby reducing the yield you receive on your investments. For those with money in cash, the more cash you carry the more your purchasing power will get clobbered by inflation. Fixed income investors are also hard hit by inflation. If you receive 5% on a bond, for example, and the going inflation rate hits 5.5%, your real return is -0.5%. Your wealth is shrinking.

The good news is that there are myriad inflation-fighting investments, including:

*    Shares in stocks in the energy and precious metals sectors tend to perform well during times of inflation.

*    Hard assets like gold and silver tend to rally on inflation expectations.

*    You can fight inflation by buying stocks which ordinarily offer higher returns than cash and fixed interest, providing a buffer against inflation. Generally speaking, a company’s revenue and earnings should increase at the same pace of inflation because companies can lift prices as costs rise.

*    Hard assets like property can stand up to the onslaught of inflation provided that the property market isn’t already at the top of its cycle.

When inflation has become unruly in the past, Governments have historically reacted by upping the cash rate.

So if rising rates are on the agenda, how should you position your investments?

First up, you’ll probably want to avoid fixed interest products, deposits and funds with long maturities because you’ll lose out if interest rates rise (in other words, if you buy long-dated fixed interest products now and interest rates rise in the future, the interest you receive will be lower than future bonds issued with similar maturity and quality). You might be better off sticking with shorter dated securities instead.

High dividend-paying stocks are definitely an attractive option should inflation and higher rates begin to plague markets. Plenty of stocks on the ASX offer dividend yields that will well and truly cover the eroding effects of inflation, plus, give you the added potential of capital appreciation.

On average, high-yielding stocks tend to hold up better than growth-style stocks if the sharemarket takes a hit. Many yield-hungry investors will hold a stock just for its dividend, even if its share price temporarily declines. This provides a floor under the share price and can give investors in dividend paying stocks extra piece of mind. On the flipside, punters on growth stocks are more likely to ditch the stock at the first signs of nervousness. (But growth-style stocks tend to run harder when the sharemarket takes off again)

It’s true that retirees are one group that can actually benefit from higher interest rates. Returns from cash investments including term deposits and Government bonds go up in line with the cash rate. However retirees must be vigilant that inflation does not eat into this return, leaving them much the same or even worse off.

To ward off the eroding affects of inflation, some may consider higher-yielding investments such as hybrid securities – which, in fact, are offering some of the best yields on the marketplace at the moment. Hybrids offer investors a predictable rate of return or dividend for a set period, and at maturity, may convert to ordinary share, cash, or a mixture of both, or may be ‘reset’ for another term.

Whatever your course of action, never forget the risk/reward trade-off – for every extra 1 per cent in yield you’re taking on an extra level of risk.

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