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Stocks to Fight the Coming Inflation Wave

http://www.fool.com/investing/dividends-income/2009/02/17/stocks-to-fight-the-coming-inflation-wave.aspx

Todd Wenning
February 17, 2009

The recession has erased approximately $10 trillion of individual and nonprofit net worth in less than a year and has forced investors to rethink many of their strategies that had assumed high rates of inflation. The rapid sell-off of assets combined with the sharp reduction in consumer spending has put tremendously uncomfortable deflationary pressure on the economy.

Deflation is the inverse of inflation -- where too many goods and services chase too few dollars, resulting in lower prices.

Well, that doesn't sound too awful
While lower prices may sound like a good thing at first blush, a sustained period of deflation spells disaster for an over-leveraged economy like ours since existing debts become more expensive. In such an environment, companies are obliged to cut prices to keep customers, reduce employee salaries, cut benefits, or initiate layoffs simply to stay afloat. If such desperate measures fail, many companies would be put out of business, as was the case in the Great Depression.

Federal Reserve Chairman Ben Bernanke, one of the world's foremost scholars on the Great Depression, understands the utter damage done by deflation in the 1930s, which is precisely why he's using every tool at his disposal to reinflate the economy by flooding it with more dollars and lowering interest rates. The Treasury Department and Congress have taken complementary measures to kick-start the economy through TARP and the proposed stimulus package.

A lot of attention has been given to the government's plans, but unfortunately little attention has been given to how the government plans on paying for all of this.

Elementary, my dear Watson
A simple assessment of the facts shows that the government is heavily reliant on cheap credit in the form of U.S. Treasury debt securities to fund its initiatives. The Treasury, for instance, recently announced it would need to borrow a massive $493 billion in this quarter alone and that it would increase the frequency of 30-year Treasury bond sales and reintroduce the seven-year note for the first time in over 15 years.

It's a sweet deal for them. Current Treasury yields range from 0.27% for the 3-month bill to 3.68% for the 30-year bond, so they'd be crazy not to use Treasuries, but it's simply not a sustainable model for funding economic programs. For one, Treasury yields are this low because panicked and unsure investors around the globe flooded into our government-backed bonds for safety. 

This created a bubble in Treasury prices (bond prices and yields move in opposite directions), but that trend may begin to reverse as investors are already emerging from their bunkers and discovering some quality corporate bonds offering much better yields -- recently, a two-year bond from Dow Chemical (NYSE: DOW  ) posted a yield to maturity near 8% and an Alcoa (NYSE: AA  ) bond maturing in June 2011 fetched almost 11%. Yes, these bonds are riskier than similar two-year Treasuries that are yielding 1%, but both corporate issues remain "investment-grade" and those yield spreads are enough to make investors consider such alternatives.

If income-thirsty investors flee from Treasuries or if a major foreign buyer like China stops buying new Treasuries, the government yields would increase and make borrowing more expensive. In this case, the Federal Reserve would be compelled to print even more money to make ends meet. That would further expand the monetary base -- bank reserves and currency in circulation -- which has already doubled in less than a year, flooding the economy with even more cash.

Sure, these efforts may have slowed deflation in the short run, but once asset prices moderate, the Fed is relying on its ability to raise interest rates to sop up all that extra cash it had created by selling Treasury bonds.

If that sounds overly simplistic, you're right. In fact, the Fed doesn't seem to have an exit strategy yet. As Bernanke recently noted in a lecture at the London School of Economics, their current approach is to "Put out the fire first and then think about the fire code."

As well-intentioned as that comment may be, the apparent lack of an exit plan compounds existing market uncertainty and calls into question the Fed's ability to pull liquidity out of the market at the right time. If it can't, I believe high inflation is a certainty.

No love for inflation
Even with all these signs pointing to future inflation, the market sure isn't buying it yet. According to recent Barclays Capital data, the yield spread between Treasury Inflation Protected Securities (TIPS) and regular Treasuries implies 2.5% deflation this year followed by 0% inflation through 2014. That is, in a word: Unlikely.

Unless you believe the economy will remain in a recessionary state for the next five years, all signs seem to be pointing not to sustained deflation, but to the likelihood of higher inflation. And with the market currently betting to the contrary, now is the time to go shopping for inflation-fighting assets.

A new hope
Fortunately, investors have many options for fighting inflation, including TIPS and commodity-linked exchange-traded funds, but another great option is dividend-paying stocks with plenty of room to pay increasing dividends. With the S&P dividend yield near 20-year highs, it's the perfect time to find stocks with:

  • Dividend yields equal to or greater than the 10-Year Treasury (3%).
  • Plenty of room to increase their dividend.
  • The added potential for capital appreciation.

Company

Dividend Yield

5-Year Trailing Dividend Growth Rate

Levered Free Cash Flow Payout Ratio

Johnson & Johnson (NYSE: JNJ  )

3.2%

14%

57%

ConocoPhillips (NYSE: COP  )

4.1%

19%

19%

United Technologies (NYSE: UTX  )

3.3%

19%

25%

Waste Management (NYSE: