Inflation on the Rise? Five Sectors Set to Rise

Earlier this year in our 2011 outlook, we pointed out that the growing threat of inflation … both in the US and especially in emerging economies … is one of the key issues for investors this year.

The latest batch of inflation reports shows why. First, we’ll take a closer look at the numbers. Then, we’ll show you how inflation could impact your portfolio … and provide some investment options you may want to consider.

The latest report on US consumer prices seems tame at first glance, with the headline consumer price index (CPI) up only 0.5 percent in March. Excluding food and energy, core CPI inched up just 0.1 percent. But the devil, as always, is in the details. ¹

Energy costs jumped 3.5 percent last month and have been on the rise for nine straight months, up 23.7 percent over the period. As a result, headline inflation moved higher on a year-over-year basis, up 2.7 percent. The core rate also rose to 1.2 percent.²

Conveniently, the core measure of CPI excludes volatile food and energy costs, since these increases are considered transitory. Inconveniently, both food and energy costs have been consistently surging higher for some time now.

Partly, this is a story of sharply higher import costs. As the US dollar sinks to new lows, import prices jumped nearly 10 percent last month alone, thanks mainly to a 31 percent surge in oil prices! But other import costs are on the rise too, including food prices, which jumped almost 19 percent in March.³

Emerging markets bear the brunt of rising food costs even more, since food prices account for a much larger share of the CPI calculation in most developing economies.

China, for instance, saw its CPI jump 5.4 percent in March, the biggest increase in almost three years. Two-thirds of that increase came from food prices, which rose 11 percent.

And it’s not just China … India’s wholesale price index soared to almost 9 percent last month, highlighting the fact that inflation is one of the biggest threats facing emerging markets right now.⁴

When it comes to the impact inflation could have on your own investment strategy, there are a few asset classes that could benefit, and others that may be at a big disadvantage.

Advantage: Commodity-Related Stocks

First, basic materials and energy sector stocks are obvious beneficiaries of this trend, and it’s no surprise that both sectors have been among the best performers in the stock market over the past twelve months. At Banyan Partners, we are currently overweight energy and materials, and we believe both sectors should continue to outperform with inflation on the rise.

In both cases, there are big-picture trends at work driving performance. And we believe the growing appetites of emerging market consumers for both food and energy will be a driving global force for decades to come.

Still, these two “high beta” sectors of the economy can be notoriously volatile. These stocks may not be for the faint of heart and should be owned as just one part of a well-diversified portfolio.

Disadvantage: Long-Term Bonds

One asset at a clear disadvantage in a climate of rising inflation is longer maturity bonds. In a recent article, we discussed in detail the headwinds created for investors in longer-term bonds from rising interest rates and inflation.

This scenario could spell double-trouble for bonds.

First, higher rates put existing bonds at a disadvantage in terms of yield, potentially resulting in capital losses for holders of existing bonds.

Second, higher inflation can steadily erode the purchasing power of fixed coupon interest payments, not to mention the value of principal at maturity.

For these reasons, we’ve consistently advocated shortening the average duration of most investors’ bond holdings, to about five years or less, so they face less interest rate risk.

Also, you may want to take a closer look at bond surrogates, alternatives to traditional bond holdings that are not without risks of their own, but can offer some unique advantages in a climate of rising inflation.

Finally, another key step you don’t want to overlook is reexamining the sector allocation within your overall portfolio.

Advantage: Stocks with Natural Pricing Power

Certain sectors of the market perform better than others in an inflationary climate. It all comes down to pricing power! Companies that have it can easily pass along cost increases and are better positioned to thrive when inflation is on the rise. One example is the consumer staples sector.

Think of Coca-Cola (NYSE: KO) or Johnson & Johnson (NYSE: JNJ), for instance. As input costs rise, it’s relatively easy to pass along the increase by raising the price of a can of Coke or a box of Band-Aids by a dime or quarter. In an inflationary climate most folks won’t notice and will keep drinking Diet Coke just the same. These companies have strong brand recognition and pricing power on their side, making sales much less sensitive to the threat of inflation.

Another industry with pricing power is health care. We are all painfully aware that health care costs have been rising much faster than the overall inflation rate for years, even during periodic bouts of deflation. Of course there are powerful demographic trends at work here: An aging population gives health care companies tremendous pricing power. As a result, we believe health care companies like
Pfizer (NYSE: PFE) should be well positioned.

A third sector that is somewhat insulated from inflation is telecom. Companies like AT&T (NYSE: T), for instance, are quasi-monopolies. They face very little competition so it’s easy for them to raise prices at will. Just look at cell phones.

If you’re hooked on your iPhone like I am, then you are painfully aware there was only one game in town for several years, AT&T. Now there’s finally an alternative for iPhone addicts: Verizon Wireless, which is 45 percent owned by telecom giant Vodafone (NYSE: VOD) also offers it, making VOD more attractive, in our view. I still haven’t seen much price competition for iPhone service, which means both companies now have the advantage of pricing power.

At Banyan Partners, we want to be ahead of the curve should inflation make a comeback, so we’ve already begun shifting our asset allocation in favor of more defensive sectors like staples, health care and telecom. Stocks in these sectors that can maintain strong pricing power are better positioned to not only survive, but thrive with inflation on the rise.

Good investing,

Mike Burnick
Director of Client Communications

Banyan Partners, LLC