Rising consumer prices often dampen earnings.
Higher consumer prices typically mute portfolio returns. “Inflation creates higher costs for companies to produce their goods and services,” says Jeremy Bryan, portfolio manager at Gradient Investments. To cope with inflation, companies may have to raise prices, accept lower margins or cut costs. “That can have a negative effect for stocks that cannot pass price increases through to their customers, as lower margins mean less earnings for shareholders.” With economic forecasts calling for 2.6 percent inflation by year’s end, now’s the time to whip your portfolio into shape. The following seven sectors are a natural hedge against inflation, but watch out for their Achilles’ heels.
Gold keeps pace with inflation, unless rates rise.
The classic inflation hedge, gold, tends to rise in price along with inflation. The drawback is that gold pays no dividends and neither do many gold-related stocks, like mining companies, says Matthew Peck, co-founder of SHP Financial. Investors should also consider the interest rate outlook, says John Thomas, chief investment officer at Global Wealth Management. Rising rates make the dollar more attractive than gold, and “a stronger dollar is too much of a headwind for gold prices to move higher.” For direct gold exposure, investors should try iShares Gold Trust (ticker: IAU), Peck says; the VanEck Vectors Gold Miners (GDX) invests in gold-mining companies. Both are exchange-traded funds.
Real estate is not rate-proof.
Real estate’s low correlation with stocks makes it a natural inflation hedge. “Historically, retail real estate has been the best hedge against inflation, but the Amazon (AMZN) effect on retail makes you question how retail real estate will look over the next three to five years,” Thomas says. He says self-storage stocks, like Extra Space Storage (EXR) and Public Storage (PSA), may be better because “supply constraints in the sector offset rising rate concerns.” For real estate investment trust investors, Bryan has this caveat: “Inflationary periods can also have rising interest rates, which create higher borrowing costs for the real estate provider.”
Energy stocks are often volatile.
Historically, energy stocks have offered good protection against inflation, Peck says. “With inflation, it’s all about the ability to increase prices and keep profit margins the same, and energy stocks have that ability.” He says investors have a variety of energy stocks to choose from, including Chevron Corp. (CVX) and Exxon Mobil Corp. (XOM), as well as the alternative energy stocks that PowerShares Global Clean Energy ETF (PBD) invests in. Energy stocks, though, can be volatile as oil supplies fluctuate and political conditions change. In early May, oil prices hit a new three-year high and then plummeted before rebounding thanks to OPEC production caps.
Financial stocks can get hurt.
When accompanied by rising interest rates, inflation can boost financial stocks. Peck says higher rates increase profit margins for companies like Bank of America Corp. (BAC), Citigroup (C) and JPMorgan Chase & Co. (JPM), as they can charge borrowers more. Still, there are limits to inflation’s benefits. When inflation rises too rapidly or outside the scope of projections, “that can stifle economic activity and be negative for financial stocks,” Bryan says. At the moment, the economy is strong, Bryan says, and inflation seems to be increasing at a relatively stable pace.
Health insurers could fare well.
“Health care stocks that have pricing power can receive a boost from rising prices,” Bryan says, with health insurers and pharmaceuticals likely to be the biggest beneficiaries. Pharmaceutical companies Esperion Therapeutics (ESPR) and Alexion Pharmaceuticals (ALXN) have potential, while insurance industry stalwarts like UnitedHealth Group (UNH) and Aetna (AET) should also fare well amid rising inflation. The biggest danger to the sector is how changes to health care legislation or government funding for health care programs may affect stock prices.
Beware of debt in tech companies.
Tech companies often can adjust pricing without hurting demand for their products or services, Peck says. “Netflix (NFLX) has been doing fantastic because its subscribers have increased, and Wall Street knows that at any time Netflix could increase its monthly fees and generate an increase in cash flow.” Peck says investors should look for companies that have a large piece of market share already and can raise prices without driving customers away, like Amazon.com, which recently hiked its annual Prime membership fee 20 percent. Newer companies, though, often depend more on debt financing and are more likely to be affected by rising rates.
Consumer discretionary stocks are not immune.
Inflation reduces consumer purchasing power so even consumer discretionary stocks aren’t immune. The key is whether the company can successfully raise prices to keep pace with higher production costs. “This is what will separate the winners and the losers in each industry,” Bryan says. Consumer staples stocks often struggle to pass costs on to consumers, but consumer discretionary companies in favorable markets are better equipped to do so. Bryan points to Starbucks Corp. (SBUX), Lowe’s Companies (LOW) and Home Depot (HD) as examples of consumer discretionary companies to consider when inflation rises.
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7 Classic Inflation Hedges and Their Thorns originally appeared on usnews.com
