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How to Invest for Tomorrow's Inflation

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Bond investors have been walking on thin ice for quite a while. Now that bonds have fallen considerably from their recent highs, the cracks are getting louder. And what the bond market is signaling right now is the reawakening of a long-sleeping giant: inflation.

Bond divergence
Over the past two weeks, bonds have suffered a much-needed correction after an incredible run-up this year. After falling below 2.5% in late August, the yield on the 10-year Treasury has quickly risen a quarter-percentage-point, a pretty big move by bond-market standards. This has hurt many investors, especially those who own bonds with long maturities: One long-term Treasury bond ETF has fallen 6% from its 52-week high just a dozen trading sessions ago.

One part of the bond market, however, has barely budged. The small niche area of inflation-protected bonds, also known as TIPS, has actually seen prices rise slightly over that same time period. The iShares Barclays TIPS Bond (NYSE: TIP  ) ETF hit a 52-week closing high yesterday and has gained more than 5% for the year.

What that's suggesting is the long-anticipated rise in inflationary expectations is finally starting to happen. Given how much damage inflation can do to your portfolio, it pays to know what to do to protect yourself before it's too late.

Go beyond the obvious
When many people hear inflation worries, they immediately gravitate to their old standby list of inflation-sensitive investments. They include things like the following:

  • Gold. Investor interest in precious metals has skyrocketed in the past 10 years, as the yellow metal in particular has quadrupled in price. The SPDR Gold Trust (NYSE: GLD  ) has taken off, with the ETF now owning more than 40 million ounces of gold worth around $50 billion. A host of other ETFs focusing on both bullion and gold mining stocks have launched to great demand.
  • Commodities. Investing in commodities became a lot easier in 2007 and 2008, when prices of many food- and energy-related commodities skyrocketed. The United States Natural Gas ETF (NYSE: UNG  ) nearly doubled between Aug. 2007 and June 2008 before the end of $150 oil turned the boom into a bust.

But traditional inflation hedges won't always work. Gold's big rise has come in an environment of almost no inflation, raising the strong possibility that the historical link between gold prices and higher inflation may be broken. Meanwhile, demand for commodities seems driven by macroeconomic factors and long-range supply concerns; BHP Billiton's attempt to buy out PotashCorp is based in part on BHP's role in supplying China with the materials it needs to supports its rapid growth and huge population.

Companies that can keep up
When facing inflation, however, many people don't think about the companies that can thrive in any pricing environment. Consider Starbucks (Nasdaq: SBUX  ) , for instance. Many have been concerned that a rise in coffee prices would hurt the company, forcing it either to pass on price increases to customers or eat the extra cost. But would most Starbucks customers really quail at paying $3.60, rather than $3.50, for their daily latte? Despite the company's recent foray into the lower-end market, spurred by competition from McDonald's (NYSE: MCD  ) , the typical Starbucks customer is more concerned about quality than price.

The same goes for time-tested brands whose product prices are already largely unrelated to what goes into their manufacturing. Nike (NYSE: NKE  ) doesn't have to worry too much about fabric prices and their impact on the cost of making shoes that retail for $100 or more. Coca-Cola (NYSE: KO  ) and its 23% net profit margin comes largely because producing a 20-ounce bottle of Coke doesn't cost anywhere near the $1.50 you pay for it. In fact, those companies may actually benefit from inflation, because they can raise prices in an inflationary environment and sustain or grow profit margins on a larger sales base in dollar terms.

Get ahead of the curve
Whether the latest whiff of inflation turns out to be the real thing or another false alarm remains to be seen. But by looking for unconventional ways to protect your portfolio from future inflation, you can position yourself to profit from great companies, no matter what happens to prices down the road.

Steer clear of the riskiest stocks. Matt Koppenheffer knows five dangerous stocks, and he's not afraid to name names.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger groans when he sees prices rise. He doesn't own shares of the companies mentioned in this article. Nike and Starbucks are Motley Fool Stock Advisor picks. The Fool has opened a diagonal call spread position and written puts on United States Natural Gas. The Fool owns shares of Coca-Cola, which is a recommendation of Motley Fool Inside Value and Motley Fool Income Investor. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy hates to see chocolate prices go up, but figures that as long as vegetable prices go up, too, it's still getting a good bargain.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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