July 2008

Like an old nemesis long forgotten but hardly missed, inflation has returned to complicate the lives and menace the portfolios of investors worldwide.

Thankfully, it’s not the double-digit variety that sank stock and bond investments in the 1970s and early ’80s. Still, consumer prices are rising fast enough to affect financial markets and complicate policy decisions by the Federal Reserve.

There’s no doubt that inflation hurts the wallet. It would take $657 in today’s currency to buy what $100 fetched in 1965.

Stocks are a valuable hedge against the erosion of purchasing power. That’s because most companies eventually can pass along their higher input costs to consumers. If inflation forces Americans to pay more for goods and services, those higher prices filter through to the corporate bottom line.

Mixed picture
Since the mid-1920s, large-cap U.S. stocks have returned about 10 percent per year, compared with a 3 percent annual increase in the consumer price index. But averages can be deceiving. Stock prices often appreciate much faster than consumer prices when inflation is low — say, between 1 percent and 3 percent — but lag the index when inflation gets out of control.

Between the late 1960s and the early 1980s, a period in which inflation was generally high, stocks actually lost about two-thirds of their value in real terms. Over the next 25 years, however, stocks handily beat inflation as consumer prices moderated.

“When inflation is rising, interest rates usually are going up as well,” says Andrew Smith, chief investment officer for Northern Trust Global Advisors. “That slows growth and hurts corporate profits in the short term.”

Yet Smith notes that not all stocks react the same way to rising inflation.

“Companies that can pass cost increases along to consumers do best in an inflationary environment,” he says.

While consumer staples — companies that make essential items like razors and toothpaste — might seem like the best candidates, it’s not always so simple.

“Some industries are very price competitive, so if Company A raises their prices, consumers just turn to Company B,” Smith says.

After all, toilet paper is, well, toilet paper. And without the ability to pass along their own higher costs, companies could see their profits — and their stock price — wither.

Still, some stocks perform better than others during inflationary outbreaks. Typically, those businesses are in commodity-based industries like oil and gas, precious metals and real estate.

“People need commodities, and they don’t cut back unless the economy stops growing,” notes Smith. “The inelastic demand/supply pattern gives those industries pricing power, which is why they perform better during inflationary periods.”

The relationship between bonds and inflation is similarly complex. Long-term government bonds have beaten inflation by an average of about 2.5 percent a year since the 1920s. But like stocks, that number masks the pain that inflation wreaks on fixed-income investments when consumer prices get out of control.

Time to reposition?
The prices of stocks, bonds and commodities already reflects long-term inflationary expectations of around 3 percent, says Smith. Whether now is a good time to reposition your portfolio depends on which side of that number inflation ultimately ends up.

“If inflation comes in higher than forecasted, commodities and Treasury Inflation Protected Securities (TIPs) will do well, while other stocks and bonds will suffer,” he says. “But if inflation ultimately settles below that 3 percent expectation, commodities may correct and TIPS will underperform treasuries.”

So what should investors do to protect themselves from rising inflation — without going too far out on the limb?

“If you’re concerned inflation will be higher than forecast, average into investments that defend well against inflation,” Smith says. “TIPS, commodities and real estate tend to appreciate with inflation. But be careful of your entry point because these asset classes become more expensive when inflation fears are high.”

In other words, invest a set amount each month or quarter into commodities or TIPs, then sit back and see what happens.

“We don’t expect a return to the stagflation days of the 1970s, but inflation has become a hot topic for investors,” Smith says. “Discussing an inflation defense strategy with your advisor is a good move.”