Picking Stocks to Keep Ahead of Inflation

Published April 13, 2011


Picking stocks to keep ahead of inflation

(NEW YORK) If investor behaviour foreshadows what's in store for the economy several months down the road, inflation could be a bigger threat than government figures now suggest.

Historically, stocks have been regarded as a decent inflation hedge.

The current numbers paint a rather benign picture, as core inflation in the United States has been growing at a modest annual rate of 1.1 per cent.

Even when volatile food and energy prices are factored in, overall consumer prices rose just 2.1 per cent over the year through February, the most recent period for which data are available.

Yet the market appears to be looking past this information. Since the end of December, investors have been pulling money out of mutual funds that invest in assets that fare poorly when inflation kicks up, like intermediate-term bonds and cash, according to an analysis of fund flows by Bank of America Merrill Lynch Global Equity Research.

At the same time, they've been pouring money into funds that invest in traditional inflation plays. Those include Treasury inflation-protected securities, commodities and, of course, stocks.

Equity funds alone have drawn US$30 billion in net inflows since the end of December, according to the Investment Company Institute, the fund industry trade group.

Of course, there is still a debate over whether these shifts make sense. Worrisome levels of inflation may not materialise at all.

Economists at IHS Global Insight, for example, are forecasting that consumer prices will grow at only around 2 per cent a year from 2012 through 2014. They say they believe that wage growth will be muted in a sluggish job recovery. My comments: You gotta be kidding. Inflation will hit US quickly, just like in 2007.

But some strategists are bracing for an inflation jump. Jason Hsu, chief investment officer at Research Affiliates, a consulting firm in Newport Beach, California, said he expected the numbers to rise in a little more than a year from now.

'We're talking about inflation hovering in the 4 per cent area,' he said, with a risk of it moving even higher. He pointed to the flood of stimulus that's been pumped into the economy by governments throughout the world.

Some central banks overseas have already reversed course and are raising rates to keep a lid on prices. The European Central Bank made such a move last week, citing worrisome levels of inflation in food and energy costs.

Even if Mr Hsu is right, though, there is still the question of how effective stocks will be in protecting portfolios amid rising consumer prices.

Historically, stocks have been regarded as a decent inflation hedge - at least relative to bonds and cash - because stock returns have outpaced inflation for most of the past century.

Yet it's not always the case. Ned Davis Research, based in Venice, Florida, recently analysed how the market performed in different inflationary environments over the past four decades.

While the Standard & Poor's (S&P) 500-stock index posted double-digit gains, on average, when inflation has been between one and 4 per cent, stocks fell at an annualised rate of 1.4 per cent when inflation jumped to between 4 and 9 per cent.

What's more, in periods when the inflation rate is accelerating, not all types of stocks perform the same way.

Sam Stovall, chief investment strategist at S&P's Equity Research, looked at periods since 1970 when the year-over-year change in the consumer price index was accelerating.

He found eight such sustained periods, and saw that half of the 10 market sectors, on average, gained ground during those times; the others declined or were flat.

Which types of equities are likely to outperform if inflation starts to heat up this time? Mr Hsu says he thinks large, domestically based multinational companies would look attractive if inflation really took off and the US dollar continued to weaken against other major currencies.

Although a weaker US dollar would effectively raise the cost of goods imported from overseas, it would lower prices for exports, thus benefiting the American multinationals My comments: I agree to a certain extent. US companies are usually brand owners, like YUM (KFC), Apple. So they are able to raise prices without the threat of consumers defecting to competitors. Asian companies do not have strong brand names. Android phones have many substitutes, like HTC, Samsung etc.

Aother promising area is dividend-paying stocks, said Kate Warne, investment strategist at Edward Jones in St Louis.

Since 1947, payouts issued by the S&P 500 companies have grown at an annual rate of 5.6 per cent, she said, outpacing the 3.7 per cent inflation rate during the period. But there is another reason to favour dividend payers, she said.

Businesses that stand to thrive during inflationary periods are those that have the power to pass along price increases to their customers.

And companies with growing dividends often have that ability. 'When you think about it,' she said, 'companies that have pricing power - and are thus able to maintain their profit margins - will be able to continue to raise their dividends.'

Brad Sorensen, director of market and sector analysis at Charles Schwab, said pricing power might be focused in certain sectors.

Historically, 'energy companies have proven they can raise prices pretty quickly at the pump if oil climbs', he said.

'On the other end of the spectrum, consumer companies have a hard time passing along price increases on things like clothes because there's so much competition.' If inflation spikes, energy has proved to be a good place to hide. My comments: Absolutely agree. My portfolio is full of commodity companies like energy stocks, e.g. Marathon Oil, Apache Oil, Rosneft, Gazprom, Tatneft.

But if the discussion moves from rising inflation to hyperinflation, other defensive areas of the market like health care and utilities would seem to make sense, Mr Stovall said. My comments: Not sure about that, but my sole healthcare stock, Humana, is doing well.

After all, no matter how expensive things become, people still need to see the doctor and turn on the lights. -- NYT