March 28, 2004
Where to Turn When Inflation Roars Again?
By J. ALEX TARQUINIO
ANY strategists see signs of higher inflation on the distant horizon and suggest that investors adjust their stock portfolios before it draws closer.
Over time, stocks tend to beat inflation. But in the short run, rising inflation can hurt stocks by squeezing profit margins. That is particularly true for companies that are sensitive to interest rates, like those in financial services and real estate, because higher inflation generally leads to rising interest rates.
Investors who want to guard against inflation should gravitate toward industries that benefit directly from it, many advisers say. In this category, they include energy and industrial materials, as well as companies that produce consumer staples like foods and tobacco products. Such companies stand a better chance of passing along higher costs to consumers.
"In times of economic weakness, if you can eat it, smoke it or drink it, then you should buy it," said Sam Stovall, chief investment strategist at Standard & Poor's.
Inflation has been mild of late. The Consumer Price Index rose by less than 2 percent in 2003, a year of low interest rates. But some recent evidence suggests that higher inflation could be at hand. The index rose a seasonally adjusted 0.3 percent in February, after a surprise increase of 0.5 percent in January. But the core inflation rate, which excludes the volatile energy and food categories, was just 0.2 percent for both January and February.
Consumers who drive a lot or live in colder areas of the country are feeling the sting of inflation in higher prices for oil and natural gas. Energy prices rose 1.7 percent in February, after spiking 4.7 percent in January, the largest one-month increase since the start of the war in Iraq.
Estimates of future inflation rates vary widely. S.& P. expects inflation to remain moderate, with the core rate up 1.6 percent in 2004 and 2.1 percent in 2005.
Still, energy prices can have a strong ripple effect, said Michael Metz, chief investment strategist at Oppenheimer & Company in New York. He said he expected that higher fuel costs would lead to greater increases in the Producer Price Index, a measure of wholesale inflation, over the next two months and in the Consumer Price Index by late spring. He expects core annualized inflation of 5 percent by year-end.
Cheap imports, particularly from China, have kept a lid on prices of many consumer goods, Mr. Metz said. But he says that he sees import prices starting to creep up, and that he does not think American productivity gains can keep offsetting higher costs.
Once higher inflation kicks in, Mr. Metz said, it has a way of feeding on itself. "Inflation is a psychological phenomenon," he said. "Vendors experiment with boosting prices, then it spreads like a contagion."
SEVERAL strategists say they expect industrial stocks to perform better than they did in the late 1990's, when the market regarded them as stodgy "old economy" stocks and favored technology stocks instead. "We have a generation of portfolio managers that buy technology, because that's what has worked," said Henry Herrmann, chief investment officer of Waddell & Reed Financial, a mutual fund company in Overland Park, Kan.
But Mr. Herrmann said some portfolio managers were starting to shift toward industrial stocks. That could raise the market capitalization of these companies, he said, to 18 percent to 20 percent of the S.& P. 500-stock index, from about 10 percent today.
"The only way to get these stocks into mutual fund portfolios is for managers to buy them, and that will push up prices," he said.
Mr. Herrmann says he likes Deere and Caterpillar because both may hitch a ride with rising commodity prices. Higher prices for industrial metals like copper, nickel and aluminum will cause an increase in mine construction, he said. Caterpillar, based in Peoria, Ill., makes much of the heavy equipment used in this work, so its earnings should increase, he said.
He also sees an agricultural boom ahead. "Protein consumption is very low in China, and it's going to rise," he said. That would push up prices for crops like soybeans and corn, which is used to feed chickens. For Midwestern farmers, who have suffered through years of lower prices, the shift would let them make purchases they have been putting off - including tractors made by Deere, which is based in Moline, Ill.
"Deere will clearly have more pricing power over the next couple years," Mr. Herrmann said. "They're going to need it, because they consume a lot of steel, and prices will be up. But I think they will also be able to improve profit margins."
Energy prices have already risen sharply, but many analysts expect them to fall back a bit. Oil traded at $35.73 a barrel on Friday, up from $28.63 a year ago, and natural gas traded at $5.40 per million B.T.U.'s, up from $5.10.
Shares of energy companies are probably a better deal now than direct investments in the commodities, said Jack Cunningham, portfolio manager of the Salomon Brothers Investors Value fund, which returned 35.62 percent over the 12 months through Thursday. "Even though we expect some commodity prices to come down, we still expect some of the stocks to be good opportunities," Mr. Cunningham said.
The market is treating shares of major oil companies as if oil prices will fall to $22 to $23 a barrel, he said. "We're still concerned about uncertainties in Iraq, Saudi Arabia, Venezuela, terrorism and the U.S. dollar," he said, so he expects oil prices to decline to $28 to $30 a barrel and linger there.
His fund owns 685,000 shares of BP, based in London, and 325,000 shares of Total, the French oil and chemical company. He says he thinks both companies have stable long-term reserves and good potential growth, and that both have good dividend yields - BP at 3.71 percent and Total at 3.5 percent.
Mr. Cunningham says that he expects natural-gas prices to remain strong and that the best investment opportunities in the category are among American drillers. The fund owns 420,000 shares of Nabors Industries, a land-based natural-gas driller, and 460,000 of Global Santa Fe, primarily an offshore driller. Both are based in Houston.
When it comes to producers of consumer goods, many analysts say the ability to pass along higher costs for raw materials and transportation is crucial.
Mr. Stovall, of S. & P., said inflation of 3 to 4 percent could even help producers of relatively low-cost necessities like cereal and toothpaste. Such businesses may be able to raise prices more readily than others.
Kellogg, based in Battle Creek, Mich., has learned how to increase sales while keeping prices high, said Carl Sibilski, a stock analyst at Morningstar Inc. "Look at all the Kellogg brands when you walk down the grocery store aisle," he said. "There was a time when Kellogg thought they could sell more cereal by lowering prices," he said. Instead, in recent years, the company has been making quality improvements like the addition of dried fruit to its cereals, he said.
Mr. Sibilski said smokers would continue to pay whatever the Altria Group, the cigarette maker, decides to charge for popular brands like Marlboro and Virginia Slims. He said Altria, formerly known as Philip Morris, had "famously passed along price hikes to cover everything from lawyers' fees to legal settlements."
AMONG the businesses that may fare poorly amid higher inflation are those that rose sharply over the last year, including those in financial services, technology and real estate.
Most financial services companies, like banks, mortgage lenders or credit card issuers, tend to be hurt by rising interest rates. Real estate, especially the richly valued American housing market, may also suffer if mortgage rates rise, analysts say.
"If rates go up, new entrants to the housing market will not be able to bid up existing homes, which is what many homeowners are counting on," said Mr. Metz at Oppenheimer.
Technology is a trickier call, some analysts say. Manufacturers have very little pricing power because customers now assume that information technology prices will always fall. On the other hand, if a technology company created a product that could make businesses more efficient, it would be better able to name its own price.
One way to gauge stock performance during inflationary times is to look back at the 1970's, said George A. Roche, the chairman of T. Rowe Price. Mr. Roche was an analyst for the company's New Era fund in 1969, when the fund was started as an inflation hedge, and later managed it.
He says that he expects a climb in inflation, though not a return to the 1970's version. "But I think the 70's provide an instructive example," he said. In that decade, energy, mining and tobacco were among the best-performing industries, while clothing, airlines and cars were among the worst.
Although Mr. Roche says he thinks a shift toward inflation-sensitive stocks is already under way, he predicts that stocks over all will be a good hedge against inflation over the next 5 to 10 years, "because you own shares in a dynamic enterprise and, over time, it finds ways to cope with the new conditions."
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