How to Play Inflation

By Daniel Kadlec

Inflation is back. the government confirmed it last week, saying that consumer prices in March surged at an annualized rate of 6.2%. The news took a toll on the markets: interest rates jumped, stocks slumped. But it's hard to know why anyone was surprised. Before the announcement, prices for raw materials--from soybeans to steel--had been soaring for two years. Wholesale food prices, like those for pork bellies and grains, rose 47% during that period; metals went up 73%.

Consumers have so far been mostly shielded from the rises for a couple of reasons. There has been little rise in workers' wages, which has kept overall manufacturing costs down, and companies have absorbed higher costs to keep their goods affordable in the jobless recovery. But new jobs are finally being created, which means more consumers can accept higher prices. Meanwhile, a surge in demand for raw goods--led by China--is adding to upward pressure on prices. Last week's inflation announcement "was a watershed report," says Mark Zandi of Economy.com He believes the uptick marks the end of 25 years of falling inflation and the onset of a long cycle--that may last perhaps 10 years--of gently rising consumer prices.

The annualized 6.2% figure isn't likely to hold. Inflation measured only 1.7% over the past 12 months, and economists figure it will clock in at well under 3% for the full year. Still, a reversal in the long-term trend will ripple through the economy. Rates for mortgages, car loans and credit cards will start moving higher. You should reduce your debt or lock in a fixed rate now. Higher rates also mean housing prices should cool. If you plan to sell your house, get to it; if you're a buyer, resist the urge to pay top dollar. Savers rejoice: rates on bank certificates of deposit and similar investments may start to rise faster than inflation.

Investors should lighten up on bonds, which lose value as inflation rises. You also might want to shift 5% to 10% of your portfolio into commodities to take advantage of the first robust market for raw materials in a quarter century. How do you do that? Leave actual pork-belly trading to the pros. You can brace for inflation with mutual funds that invest directly in commodities, like Pimco Commodity RealReturn Strategy (up 43% in the past 12 months) and Oppenheimer Real Asset (up 35%). Funds that invest in stocks of companies in the raw-materials business include T. Rowe Price New Era (up 41%), Vanguard Energy (up 43%) and State Street Global Resources (up 77%). Careful. Commodities-fund prices are volatile.

Stock pickers should consider steel (Nucor, International Steel Group), fertilizer (Agrium), farm equipment (Deere), coal (Peabody), precious metals (Newmont Mining), paper goods (International Paper, MeadWestvaco) and energy (ExxonMobil). Then, when the prices you pay at the counter go up, so should your portfolio.

You can e-mail Dan at this address: [email protected]