Concerned About Inflation?

Inflation has become a bigger topic of discussion among investors and in the media as of late, causing investors to wonder how to position themselves should inflation start to take hold.

First, despite common perception, gold has not historically been a very good hedge against inflation. This time could be different of course, but it is interesting to note that the run in gold over the past several years has been during a period of disinflation, not inflation. Due to the lack of evidence of being an effective inflationary hedge, and the possibility of gold prices being a bit extended after the recent run, we don't recommend gold as an investment for those concerned about inflation.

Interesting, it has been stocks that have historically been the best hedge against inflation. And it makes intuitive sense. Inflation comes from higher prices, which comes from companies raising prices, and many of those companies are publicly traded. Within the stock market, it has typically been those sectors that have the easiest time passing on cost increases to customers that have fared the best during times of rising inflation—typically energy and materials—while those sectors which have harder times passing costs on to consumers have fared the worst—typically consumer discretionary and consumer staples.

As we've noted many times, history doesn’t predict the future but it can provide a guide, and in this case we think it’s a fairly good one. Should inflation start to ramp up, energy companies have shown they can increase prices rapidly, while consumer-related names continue to have trouble gaining any real measure of pricing power. For those looking for some possible portfolio protection against inflation, we believe energy is a good place to start. While we believe a sizable amount of volatility will remain with turbulent evolving situations around the globe, we continue to believe that sticking with an outperform rating on the energy is the best course of action. Speculators will likely continue to pressure the price of oil higher, while global uncertainty will likely keep the risk premium in the energy sector elevated for the foreseeable future.

Meanwhile, while the consumer has been relatively resilient in the face of increasing headwinds, we continue to believe the discretionary sector will underperform in the coming months relative to the overall market. We want to note that this does not mean we think that consumer spending in going to fall off a cliff, but that there are challenges that we believe will weigh on the sector in the near term.

In addition, with the increased volatility over the past several weeks in the overall market, the traditionally defensive staples sector's performance has perked up a bit and we are watching economic developments to see if an upgrade may be warranted in the near future. For now, however, we believe the economic expansion is on track, confidence is returning, and money is rotating into domestic stocks—leading us to hold an underperform view on the staples sector.

As discussed, we continue to hold our outperform recommendation on energy and Information technology. At the other end of the spectrum, the consumer staples and consumer discretionary sector continues to be rated at underperform. Healthcare, industrials, materials, financials, telecommunications and utilities all continue to hold a marketperform rating. Our recommendations can and do change quickly at times as we continually monitor economic progress and specific factors influencing individual sectors.

Kully Samra, UK branch director at Charles Schwab, gives his views on the US market.