We've watched for a few years now as the Federal Reserve and U.S. Treasury have pumped money into the flagging U.S. economy in hopes of bringing it back to life and jump-starting growth. Optimists like me would say that it's working, but even then it's impossible not to concede that it's not working all that well.
And for the lackluster growth in gross domestic product and ailing job market, we still face the risk of inflation as the loose monetary policy continues to snake its way through the economy. On the consumer level we haven't seen much inflation yet, but companies such as Starbucks (Nasdaq: SBUX) and PepsiCo (NYSE: PEP) have as commodities such as coffee, aluminum, and corn syrup have surged in response to short supply.
Fed Chairman Ben Bernanke says we shouldn't be worried about inflation. My fellow Fool Rich Smith thinks he's mistaken.
So should you start preparing your portfolio for inflation?
Trouble is ...
It's not terribly clear what equity investors' best move is when it comes to dealing with inflation. Using data from the U.S. Department of Labor and Yale professor Robert Shiller, I found that the correlation between annual inflation and nominal changes in the S&P 500 (and its equivalent prior to 1957) between 1914 and 2010 was 0.08. What does that mean? It means that there's a weak enough relationship between the two that it would be tough to say what the S&P will do based on inflation. The correlation changes over different time periods -- it's -0.11 over the past 50 years and 0.12 over the past 30 -- but the relationship remains pretty weak.
But could there be reason to be optimistic about inflation's return? Writing for Forbes, Martin Fridson suggested that it's the rate of change of inflation and not inflation itself that matters. As such, he explains that higher inflation could be good for equity investors right now.
Meanwhile, a Peter Hodson article in the Financial Post points out that some companies may be able to use inflation to raise prices faster than their costs and thereby boost profit. Think about companies like Accenture (NYSE: ACN) and IBM (NYSE: IBM) where people, not commodities, are the primary costs.
Of course as with so much else in the stock market, the real factor at play here -- and Fridson also notes this -- is investors' expectations. Inflation could be 800%, but if the market is already priced for 1,000% inflation then investors could end up pleasantly surprised.
The way some stocks are priced right now, I find it hard to believe that equity investors will be caught flat-footed if inflation does rear up. If the market was truly ignoring inflation risks, there's no way that Ford (NYSE: F) and JPMorgan Chase (NYSE: JPM) would be trading below 10 times expected forward earnings. If investors really believed that we'd continue to have low to no inflation, those valuations would be bid up much higher. Instead, I think the market is already assuming that inflation will rise and are therefore demanding higher nominal returns.
So circling back to the question that led you here in the first place, if you're currently investing in quality companies at low prices, you may be more prepared for inflation than you think.
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