Investing: Keeping Inflation at Bay

The uptick in prices has business execs, Fed officials, and investment pros in a sweat. What steps should investors take now?

by Ben Steverman,

After decades in remission, inflation is making a comeback. Rising prices already are making consumers miserable and squeezing corporate profits, but inflation also might cripple investors’ returns if they’re not careful.

It’s not yet clear that higher inflation is here to stay, but there’s no doubt the price of many basic materials-notably fuel and food-are skyrocketing. Once firmly established, inflation will be hard to dispel, and that worries economists, investors, and the central bankers who set interest rates around the world.

There are investing strategies that can protect portfolios from inflation-some of which we describe below-but few investors can fully escape inflation’s destructive influence on the economy and financial markets.

A Sinister Beast Uncaged
Richard Fisher, president of the Federal Reserve Bank of Dallas, gave a sense of how much the Fed worries about inflation in a May 28 speech. “Inflation,” Fisher said, “is a sinister beast that, if uncaged, devours savings, erodes consumer purchasing power, decimates returns on capital, undermines reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.”

And those aren’t the only troubles inflation brings. The cure for inflation, hikes in interest rates, can be worse than the problem. Higher lending costs could not only slow down a weak economy, but also exacerbate the U.S. housing crisis.

Although there are things investors can do to prepare for inflation, few are certain to counteract its effects. That’s worrisome because evidence of inflation is everywhere lately.

Dow Chemical (DOW) raised product prices by up to 20% on June 1, after executives said the firm’s bill for energy and feedstock jumped 42% from the year before.

April’s U.S. consumer price index, a measure of all consumer costs, was up 3.9% from a year ago, with energy costs higher by 15.9% and food up 5.1%. The Fed recently revised its 2008 inflation expectations to a range of 3.1 to 3.4%, up a full percentage point from the beginning of the year. According to the Reuters/University of Michigan Surveys of Consumers, Americans in May said they expected the highest levels of inflation in more than two decades.

And it’s not just a U.S. worry: European central bankers have not cut interest rates, held back by inflation concerns, and many emerging economies are seeing costs rise, too.

The U.S. economy seemed to slow at the beginning of the year, a trend many thought would stifle inflation, says John Merrill, chief investment officer at Tanglewood Capital Management.

“In fact, inflation seems to be building,” he says.

Strong Demand Is Buoying Prices
“The global economy remains very strong,” meaning demand for natural resources is strong, too, says Susan Perkins, managing director at Provident Investment Counsel. That has pushed the price of energy and other commodities to record levels. Average gas prices are at $4 per gallon nationwide, and the price of oil hit $135 per barrel in late May before backing off recently.

Despite the worries, high inflation isn’t a certainty. The yield on a two-year Treasury note is still a low 2.5%, suggesting bond traders don’t expect a major spike in inflation. What could prevent inflation? A weak economy crimping demand for goods and services, for one thing. Also, Brian Gendreau of ING Investment Management (ING) notes that up to three-quarters of corporate costs go toward labor, and wages are actually falling by some measures.

If inflation does spike, it presents a dilemma for investors. Government bond yields are likely to rise along with inflation, while the value of bonds in a portfolio could plunge. Putting all your money in cash might be tempting, but inflation will hurt the buying power of that cash.

So how should investors prepare for the possibility of a prolonged period of higher inflation? A simple option is Treasury Inflation-Protected Securities, bonds that keep up with rising inflation since the yield is indexed to the consumer price index. Still, yields on TIPS are low, and financial adviser Kipley Lytel, of Montecito Capital Management, warns they have other disadvantages: They’re not tax-friendly for some investors, and they rely on a government inflation adjustment that Lytel thinks is too low.

Looking for a Safe Haven
The “classic formula” for dealing with inflation, according to William Rutherford of Rutherford Investment Management: “Buy things, and go into debt.” As inflation pushes up the prices of those “things”-such as real estate and commodities-it’s much easier to pay off your original debt. This can be a risky strategy, however. Commodity prices are volatile and could be approaching “bubble” levels, Rutherford says. Meanwhile, real estate values are just about the only prices in the U.S. that are falling. Plus, the policymakers’ likely reaction to inflation-higher interest rates-would make it hard to refinance high levels of debt.

Experts have a variety of advice for investors looking to protect their portfolios against inflation.

Perkins advises “looking for companies that have sustainable competitive advantages.” Demand for their products should be so strong that higher raw-material costs can easily be passed on to consumers. She recommends companies with innovative products like Apple (AAPL) and robotic surgery technology outfit Intuitive Surgical (ISRG).

Rutherford has similar criteria, looking for companies with “pricing power” during inflationary times. Dow Chemical, with its recent big price increases, clearly has that power, he says. Other examples are makers of consumer necessities, like Procter & Gamble (PG), Kellogg (K), and General Mills (GIS). “At the end of the day, people do need to eat,” he says.

Hats Off to Small-Caps
When inflation is higher, small-cap stocks benefit, Doug Roberts of Channel Capital Research says. Smaller companies do better during times of negative real interest rates, i.e. times-like now-when interest rates are lower than the inflation rate.

Lytel invests small portions of his clients’ portfolios directly in one of the prime causes of inflation: commodities. He uses exchange-traded funds like the PowerShares DB Commodity Index Tracking Fund (DBC) or the Vanguard Energy Fund (VGENX). Rutherford, however, warns against ETFs focused too narrowly on volatile commodities like oil and gold. He would rather invest in commodities through big, diverse mining companies like BHP Billiton (BHP) or Rio Tinto (RTP).

Depending on where investors put their money, their portfolios might avoid damage from inflation. But consumers, forced to pay more for gas and food, have fewer options. Americans “in the bottom half of the economic spectrum” are hit the hardest, Merrill says. “It seems like these people can’t catch a break.” That’s why, in case of inflation, Merrill advises staying away from retail stocks. “Retail in America is in a real uphill battle,” he says.

Bringing On Uncertainty
Inflation is likely to punish anyone-and any company-that’s not in good financial shape. “People and companies on the margins are going to have a tougher time,” Rutherford says.

One of the biggest problems that inflation causes is uncertainty.

Commodity markets are priced for “hyperinflation,” Roberts says, while bond markets predict little or no inflation. “One of them has to give,” Roberts says. But which one? “We’ll only know that in the rearview mirror,” Perkins says.

Investors make money by correctly predicting the future. But inflation deals a wild card, making it much harder to anticipate the direction of the economy and the markets. The best investors can hope for is that it acts like an annoying-but mostly harmless-party crasher, who pesters the other guests but doesn’t get out of control.

Steverman is a reporter for BusinessWeek’s Investing channel.