Some Investors Brace for Inflation's Return

Tom Lauricella

Even as signs of deflation linger, some investors are moving to protect themselves against any surge in inflation.

They fear the Federal Reserve will move too slowly to reverse the unprecedented flood of cash it pumped into the financial markets in response to the global financial crisis. With the crisis now seen as over, they feel the Fed could be setting the stage for a meaningful rise in inflation over the next several years by pledging to keep interest rates essentially at zero for the foreseeable future.

To defend—and profit—from a big rise in inflation, investors have piled into gold or inflation-protected bonds. In November, investors put $2 billion into inflation-protected mutual funds and exchange-traded funds, according to Morningstar Inc. Another $3.9 billion into went into commodity funds and commodity exchange-traded funds, primarily gold funds. So far this year, those categories of funds have raked in $59 billion. In contrast, investors have pulled $52 billion from U.S. stock funds and U.S. stock-focused ETFs.

But the moves go beyond just building up stakes in those traditional inflation hedges. Some investors and strategists are factoring a resurgence of inflation into their stock picking and favoring material stocks or companies with strong pricing power and even some bond holdings, such as high-yield debt.

"I'm very skeptical that the Fed is going to be able to sop up the liquidity in a timely period," says John Longo, chairman of the investment committee at MDE Group, a money-management firm for high net worth investors in Morristown, N.J., and a finance professor at Rutgers University.

Managers at his firm have added funds with sizable allocations to gold and commodities and reduced bond holdings in their model portfolio to 10% from 30% a year ago.

When it comes to stocks, "in general inflation isn't good for stocks, but you want to have companies that have the pricing power to be able to adapt," says Mr. Longo. He cites Coca Cola, as one example, and pointed to news last week that FedEx raised shipping charges, following a similar move by United Parcel Service.

For now, inflation appears still a ways off and deflation remains the reality. Few companies are in a position to raise prices and in October, the consumer-price index was down 0.2% from a year earlier. The November reading on the CPI is due Wednesday.

Fed Chairman Ben Bernanke predicted last week that inflation would be "subdued for some time" and that in the near term, inflation could fall further. Against that backdrop, interest rates could stay low "for an extended period," he said.

Some believe that there is little chance of a meaningful pickup in inflation, even a couple years down the road. The argument is that unemployment will remain high even as the broad economy recovers.

When coupled with unused capacity in the manufacturing sector, that slack should allow the economy to grow without upward pressure on prices.

Against that backdrop, stock and bond markets aren't pricing in a rise in inflation.

Based on prices of U.S. Treasury Inflation-Protected Securities, where principal and interest payments are adjusted for changes in the CPI, inflation is expected to be less than 1% in 2010, says Michael Pond, Treasurys and inflation market strategist at Barclays Capital.

Looking a little bit further out, TIPS prices suggest inflation is expected to be 1.5% per year over the next five years and roughly 2.1% over the next 10 years, according to Barclays.

Those expected inflation rates have moved higher from earlier in the year, but "the market is not at the point where it's pricing in excessively high inflation," says Kenneth Volpert, who manages the Vanguard Inflation-Protected Securities Fund.

Mr. Longo acknowledges that the TIPS market isn't even flashing warning lights about inflation, but says that for longer-term investors, the time to buy inflation protection is when it's cheap.

"The market is driven by short-term traders," says Mr. Longo. "The traders think they can be nimble and jump on the bandwagon."

But with many investors at least in part blaming the Fed for fueling the housing bubble with low interest rates in the early part of this decade, there is less confidence in the central bank's abilities to avoid an inflation flare-up. They argue that while there isn't inflation among consumer goods, there has been inflation among asset prices, such as in the stock and bond markets.

In the view of some, more important to the inflation outlook is the massive amount of liquidity sloshing around in the financial system.

Once banks pick up lending, some say that liquidity will act like a match to gasoline, igniting inflation.

Rising inflation amid an economic recovery is one reason why Morgan Stanley's European strategists are recommending, energy, materials and consumer staples stocks.

Consumer staples, particularly food and tobacco stocks, tend to do well in rising inflation, plus have the added benefit of enjoying good exposure to emerging markets, a part of the globe expected to have strong growth, says Morgan's European equity strategist, Ronan Carr.

In the bond market, the fact that TIPS are haven't priced in a meaningful rise in inflation a few years down the road means they are cheap should price pressures materialize even though they have posted big rally since this year. TIPS are priced "for the Fed getting it right," says Barclays's Mr. Pond.

At Neuberger Berman, portfolio manager Thanos Bardas argues that TIPS are cheap. But he also thinks investors should build other layers of protection. They should maximize the income potential from their bond portfolio through lower-rated investment-grade bonds and high-yield debt, he says. He says investors should maximize the income potential from their bond portfolio through lower-rated, investment-grade bonds and high-yield debt.