As we kick off 2014 with our first issue of the year, I’ve calculated the 2013 returns for both our Survive and Thrive Portfolios.

By way of methodology, I used July 16 as our inception date and assumed that as each new position was added, portions of existing positions were sold to keep each holding at an equal size. I then weighted each position by its holding period, with older positions obviously carrying greater weight in terms of overall portfolio performance.

Based on that methodology our lower volatility Survive Portfolio returned 6.4 percent during our abbreviated 2013, while the more aggressive Thrive Portfolio returned 4.8 percent. By way of comparison, using the same methodology as I described above, the S&P 500 returned 11 percent over the same period.

Best and Worst

Despite being a later addition, Norfolk Southern (NYSE: NSC) was far and away one of our best performers in the Survive Portfolio. Thanks to its heavy exposure to Appalachian coal, a commodity for which demand is falling, it has been one of the least favored of the railroads.

But as I predicted, the railroad has been steadily improving its cargo mix as the emphasis on intermodal shipping has grown. That has resulted in better-than-expected earnings reports, pushing the shares up 21.5 percent over our holding period last year and contributing a weighted average of 1.8 percent to overall portfolio performance.

As the US economy continues its slow but steady growth and consumer confidence picks up, demand for goods ranging from automobiles to household appliances will grow. The American construction market has also shown a strong recovery, boosting demand for timber and other building materials.

These trends will drive volume growth for the railroad and propel its earnings higher. At the same time, the company’s fixed assets and pricing power act as a terrific hedge against coming inflation.

Norfolk Southern remains a buy up to 92.

The greatest drag on performance was our commodities exposure. Our position in GreenHaven Continuous Commodity Index (NYSE: GCC) declined by -2.6 percent over our holding period, shaving -0.4 percent off the portfolio’s performance.

While there was some improvement in select commodities by the end of 2013, prices were generally weak over the back half of the year largely thanks to slowing economic growth in China. As the most voracious consumer of everything from metals to energy, China drives the global commodity market.

However, the link between China and commodity prices is breaking down, largely thanks to the continued health of the North American markets. A European revival will also contribute to firming commodity prices, as will the fact that many weaker producers, particularly miners, have experienced a tough shakeout and slowed production.

Despite its relatively weak 2013, GreenHaven Continuous Commodity Index faces a better 2014 and remains a buy up to 32.

Considering that our Thrive Portfolio takes on more risk, there’s a much wider differential between its best and worst performer.

Getting the bad news out of the way first, I was clearly too early with my buy call on Goldcorp (NYSE: GG). Last year it declined by -30.9 percent and subtracted a weighted -3.5 percent from the Thrive Portfolio’s performance.

I covered my gold outlook for this year in the feature article and last month’s portfolio article was devoted to Goldcorp, so I won’t belabor those points. But weak gold prices in the back half of 2013 clearly impacted the company’s earnings, since it doesn’t hedge its production and is fully exposed to the price of gold.

That said, we’re already seeing gold prices firm, mostly because of a much less benign inflation outlook for this year. So while I can’t imagine getting back to the heady days of gold at $1,800 per ounce in 2011, I wouldn’t be the least bit surprised to see gold climb back into the $1,400/oz range.

Goldcorp remains a buy under 39.

Our best performer was Pall Corp (NYSE: PLL), which makes water filtration systems. In addition to developing filtration infrastructure, it benefits from recurring revenue tied to the filter media those systems use, accounting for about 85 percent of revenue.

Pure water has and will always play a critical role in all sorts of manufacturing processes, ranging from the production of prescription medication to chip manufacturing. As the global economy has grown along with demand for those goods, Pall has turned in average annual revenue growth of 5 percent over the past decade, while net income has grown by 18.7 percent.

The company’s income growth will likely pullback to a more manageable 8 percent going forward, but margins have been showing attractive improvement as management has cut costs through selective plant closures and other measures. The company continues to trim its selling, general and administrative costs, driving further margin improvement along with revenue growth.

With demand for clean water unlikely to abate, Pall Corp remains a buy on dips below 80.

Better Early Than Late

Some would argue that 2013 was the wrong time to think about inflation hedges. The recovery in the US has been the weakest of the post-World War II period, Japan was fighting deflation, Europe was mired in recession and growth in China was slowing.

However, we argue that we were just in time.

The graph below shows the US breakeven rate, the spread between the yield of a 10-year Treasury note and a comparable 10-year Treasury Inflation Protected Security. When the spread widens, inflation expectations are on the rise. If the spread turns negative you’d better watch out, because deflation is on the horizon.

As you can see, inflation expectations hit an eight-month high on January 9 as the spread widened to 2.3 percent. While expectations have moderated somewhat in the meantime, they’re still running at their highest levels since September at 2.2 percent.

What’s driving the growing worry?

For one thing, Janet Yellen has been confirmed as the new chairperson of the Federal Reserve. An avowed dove on inflation, she’s clearly worried that the Fed’s “tapering” could slow economic growth to unacceptable levels and cause job creation to get stuck in the mud.

Even if the tapering goes off as planned, with purchases declining by $10 billion per month, the Fed’s balance sheet will still grow from $4.1 trillion at the beginning of 2014 to $5 trillion by the end of the year. The Fed’s policy rate will also likely remain at what amounts to 0 percent at least until early 2015, so there’s still plenty of easy money to be had in the US.

This situation is much the same across the pond.

While the Europeans haven’t been as reliant on fiscal stimulus as the US, they haven’t been shy about pressing monetary levers.

In November, the European Central Bank (ECB) cut its key refinancing rate to 0.25 percent in November, a record low, and its marginal lending rate to 0.75 percent. The deposit rate at the ECB remained at zero, meaning regional banks making deposits with the central bank receive no return on their money.

During the ECB’s policy meeting earlier this month, it decided to leave all of its rates unchanged. Worried about a weak recovery, it’s unlikely to boost its rates anytime soon. In fact, if the recovery appears to be truly in danger, the only real option left to policymakers would be to embark on a quantitative easing program of its own.

Throwing an abundance of easy money into global growth is like adding fuel to an inflationary fire, especially when the International Monetary Fund just increased its global growth forecast to 3.7 percent.

As my colleague Richard Stavros pointed out in last week’s Survival of the Fittest, “Money Managers Go Big on Inflation,” those factors are even driving the major investment firms into inflation-focused trades of late.

The upshot: We were “spot on” by sounding the inflationary alarm last year, positioning us for a profitable 2014 as our warnings come true and our proactive steps bear fruit.

Allocation

With the inflation outlook heating up, this is an opportune time to reemphasize the mission of our portfolios.

Our Survive Portfolio is tailored for investors in or near retirement who, while desiring some capital gains, are primarily concerned with current income and capital preservation. As a result, the portfolio focuses on more conservative investments, reducing the potential for losses.

Our Thrive Portfolio is primarily geared towards younger investors with longer time horizons who are less risk-averse. While wages have largely lagged the pace of inflation in recent years, earning a potentially rising income is not only an inflation hedge in and of itself, it also allows for time to make up any losses.

While we work to build well-balanced portfolios that should at the very least hold their own in any environment, they are specialty portfolios nonetheless. We recommend that most investors should allocate at most 10 percent to 15 percent of their portfolio holdings to our recommendations. Those with longer investment horizons who have more time to make up for inflation should keep their allocations to the lower end of our guidance range, while those with shorter horizons should use a higher allocation.