Kung fu inflation fighting

By Jason Chow
Globe Investor Magazine Online, June 20, 2008

Beware the great inflation monster.

Investors think they've been hearing its ugly growl and have responded by dumping stocks this past week. Inflation fears were blamed for the Shanghai composite index's major 7.7-per-cent dive earlier in the month, prompting brokerage firm HSBC to tell clients to dump some of their Asian emerging market holdings. Meanwhile, U.S. Federal Reserve chairman Ben Bernanke said that high oil prices have heightened inflation fears in the United States and our own Bank of Canada held off on an expected interest rate cut because of the much-loathed i-word.

Admit it, folks. All signs point to higher inflation. But how to protect your portfolios? Here are a few ideas.

Buy the companies that are doing the inflating.

Remember, inflation means rising prices and the reason why prices go up is that there's too much demand chasing too few products. And when that happens, it's best to invest in companies that are making the in-demand stuff.

What is in demand these days? Oil, agricultural products, base metals, coal - almost all commodities -are rising in price. The thinking is, invest in these sectors and you can even profit from inflation. Think exchange-traded funds that focus on the big commodity names, like the iShares Canadian S&P/TSX Capped Energy Fund (XEG/TSX) or Claymore Global Agricultural ETF (COW/TSX).

Some will argue that these commodities are in a bubble and poised for a downturn in prices. Even so, Jerry Castellini at CastleArk Management in Chicago told CNBC viewers to stop paying attention to oil prices and just buy the stocks. "Why is it impossible for an oil and gas company to be a growth business?" he asked rhetorically.

Oil is the new gold. (But gold is good too.)

In the past, the natural hedge against inflation has been to buy gold. The thinking was that gold has intrinsic value; paper currency doesn't. But some - obviously the ones who don't think oil is overvalued - are arguing that oil is actually the real inflation hedge this time.

"Not only is oil more expensive due to demand, but also our weak currency makes it more expensive, while buying oil increases our trade deficit and further weakens our dollar," writes trader Michael Filloon on SeekingAlpha.com. "Realizing this vicious circle, those wanting to hedge against inflation have turned to buying oil."

But gold is still the traditional inflation hedge and the gold-vs-oil debate is destined to continue for a long time. There's an easy way out of this: Just buy both, says Garry White, editor of Smart Commodities UK.

"You need to own both gold and oil. Then you can ignore these debates about which is the better hedge."

Israeli bonds.

An eclectic call, for sure, but Lehman Brothers sees Israeli bonds as inflation-fighters.

According to the brokerage firm, the country has one of the few countries that has "actively inflation-fighting central banks as well as countries with appreciating currencies to deflect domestic price pressures," the brokerage firm said in a note. The firm says the country's government bonds are yielding 6.69 per cent, far higher than the global average of 3.76 per cent.

Getting your hands on some Israeli debt may be tough, though. There is no ETF focused on only Israeli bonds though the SPDR DB International Government Inflation-Protected Bond ETF (WIP/Amex), which is a bond fund that is indexed to inflation, does hold about 5 per cent of its holdings in Israeli bonds.

Real estate.

While the real estate market seems to be cooling down and given that real estate investment trusts are interest-rate sensitive, this pick seems a bit odd. But analysts are reminding investors to keep in mind that REITs are bargains. First of all, real estate, like gold, is a physical asset.

Secondly, REITs were clobbered in the market last year and are now posting yields of 5 per cent, far superior to U.S. Treasuries. S&P REIT analyst Robert McMillan has been recommending high-end U.S. shopping mall REITS. His rationale: Retailers sign long-term leases and even if the American economy slows, they won't be closing down shop any time soon.