Stock sectors: Protect yourself from the coming rise in inflation

When you join my Inner Circle service, you get to ask me your own personal investment questions, plus you get to see what other Inner Circle members have asked. So you can see how the service works, and get a sense of how it might be able to help your portfolio, I’d like to share a recent member question about inflation’s impact on different stock sectors. I hope you enjoy and profit from it.

Q: Pat: If an investor is expecting a surge in inflation in the U.S. within the next 12-18 months, which stock sectors should we invest less in, and which sectors would benefit from high inflation? Thank you.

A: Governments have dramatically increased spending in order to pull their economies out of recession. Moreover, central banks have cut interest rates to record lows. These moves will likely help solve the financial crisis. But the cost will be much higher inflation, possibly starting in the next decade. This will have an impact on all stock sectors.

Higher inflation would come as a result of the large increase in the amount of money in the global financial system. Inflation can be defined as a persistent rise in consumer prices, or a persistent drop in the purchasing power of money, caused by an increase in currency and credit that is out of proportion with the amount of available goods and services.

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In other words, if at some point more money is chasing the same amount of goods and services, it will push up the prices of those goods and services.

Our feeling is that from an investment point of view, you should keep this inflationary potential in mind, but it’s too early to try to profit from its impact on different stock sectors.

For example, inflation typically pushes up the prices of commodities. That makes resources one of the stock sectors that can be a useful inflation hedge in a portfolio. But resource stocks operate in one of the most volatile and erratic stock sectors. It’s better to be late and/or under-represented in this sector, rather than to get in early and sit through a slump with too much committed to this volatile sector.

Over the next year or even two, resource prices are likely to be highly erratic as the economy struggles to get back to normal. Meanwhile, commodity consumers are likely to find innovative ways of making do with less, including redesigning products, substituting materials and so on. This will whittle away at demand growth. At the same time, new production that was set in motion during the boom will come on stream.

Even many of the most pessimistic observers now feel that resource prices are bound to rise over the next few years, as millions of Indian and Chinese workers pole-vault into the middle class. But many pessimists felt the same way following the last great resource-and-commodity boom, which occurred in the 1970s and 1980s. After that boom ended, resource stocks went into a slump that lasted more than 15 years.

We strongly doubt that we’ll see anything so extreme this time around. But we plan to err on the side of too little rather than too much resource exposure over the next few years.

So, rather than looking for specific companies or sectors that will gain the most from inflation, we’d stress that you should follow our standing advice: mainly invest in well-established companies, and spread your money out across the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; Utilities).