Henk Potts, equity strategist at Barclays Wealth, suggests that mining companies can provide a degree of protection against a return of inflation.

Over the past month, equity markets have moved to price out the risk of a re-run of the 1930s ‘Great Depression’ and now the worst-case scenario is a very severe recession. Signs of a recovery have provided a significant lift to commodity prices, with Brent crude hitting US$70 a barrel and the Goldman Sachs Commodities index some 19.2 per cent higher in dollar terms over Q2.

Entering the second half of the year, the rally in markets seems to have slowed down a bit, with the oil price back at $61 as I write. While previous price moves had buoyed commodities, a return to a boom in prices looks unlikely, and significant surplus capacity within the global economy should keep inflationary pressures in check for now.

Inflation subdued in the short term
We don’t believe oil will head back to its high of $150 any time soon, so we judge that the short-term risk of an inflation shock is slight. But, in the longer term, inflation expectations are likely to pick up again, as evidenced by the weakness of the dollar and rising US Treasury yields in recent weeks, while continuing industrialisation and urbanisation in the ‘BIC’ bloc – Brazil, India and China – should boost commodity prices.

Investors who want exposure to the nascent economic recovery, and some insurance against rising inflation expectations, could do worse than invest in mining companies. Theoretically, the earnings of these companies should be sensitive to both global GDP trends and any generalised rise in consumer prices. Moreover, this is one sector where we still see some good upside to our fair values, despite the strong equity rally since early March.

There are three UK stocks that we feel warrant investors’ attention. Among the large-cap, diversified commodities and materials providers, we continue to prefer BHP Billiton and have also turned more positive on Rio Tinto.

A core holding
Having been the best-performing miner in 2008, BHP Billiton has lagged peers so far this year, as investors have preferred buying into companies with overly depressed outlooks (ENRC) or balance sheet restructuring stories (Rio). Looking ahead, we continue to believe BHP should be a core portfolio holding in the materials sector, alongside higher-beta names such as Vedanta, as commodity market conditions remain uncertain.

BHP is arguably the most defensive name in a highly cyclical sector, but still offers good exposure to rising commodity prices, high-quality assets and a superior operational track record. Its balance sheet strength offers good flexibility for growth opportunities, and with a disciplined management team we believe execution risk is relatively low. As other miners have rallied over the past few months, BHP is now trading at a discount to peers on 2009 calendar estimates. We have a buy recommendation with a fair value of £18.

Contrasting position
Meanwhile, post its right issue, BHP’s peer Rio Tinto is now strongly capitalised and favourably positioned for future growth. Importantly, China’s Chinalco took up its full rights entitlement in Rio Tinto Plc, showing that it remains committed to Rio (and mining in general), despite the somewhat acrimonious failure of the proposed tie-up between the two companies. Rio’s management has preserved its reputation by stepping away from the Chinalco deal and seeking to maximise shareholder value. The planned joint venture with BHP in iron ore provides a further major positive for both companies, with combined cost savings expected to amount to some US$10 billion annually.

A more exciting – if somewhat more risky – play on a recovery in commodities is copper miner Vedanta Resources. The company has seen its share price more than double in the year to date, as it is one of the most exposed companies to commodity markets recovery and demand growth in India, as well as one of the smallest diversified miners in terms of market capitalisation.

Consequently, it is riskier than BHP Billiton or Rio Tinto. However, Vedanta’s profits growth should remain underpinned by high-quality resources, lower capital costs than the industry average and solid financial flexibility, enabling the company to pursue organic capital expenditure to drive further growth.

Additionally, the company has a clear emerging markets focus, which fits our strategic view that ‘emerging’ economies will recover faster than the so-called ‘advanced’ ones.