Wednesday, February 4, 2009

WCAM: How Inflation Became the Good Guy

Inflation has been an all-purpose bogeyman since the 1970s, but a small amount of inflation comes with a healthy, growing economy. The Federal Reserve focuses on managing inflation, not preventing it. We have written often that we feel the government measures inflation incorrectly, since the Consumer Price Index undervalues food, healthcare and energy costs. As a result, excessive inflation builds for a while before the government acknowledges it, and comes as a surprise, despite our constant measurement and analysis.

But the consumer price index is only one measure of inflation. Another is the Producer Price Index (PPI), which measures inflation faced by people who buy raw materials to create other products. Watching the constant rise of producer prices over the past years, as consumer prices appeared stable, a thoughtful observer sensed that “something’s gotta give.” Add a significant credit crisis, a sudden liquidity crisis, a Fed Chairman who dreads the Great Depression’s deflation, and the table is set for significant inflation, and the possibility of hyperinflation.

The current economic crisis raises the specter of both deflation and hyperinflation for many economists and journalists, and “specter” is the operative word here. Studying deflation and hyperinflation is a little bit like studying Bigfoot and the Loch Ness monster. Deflation and hyperinflation are real, but there is as much lore as evidence in the popular press and on the Internet. In times of crisis, one struggles to separate political agendas and fear mongering from analysis.

With our currency likely to be dropping in value and our interest rates likely to be moving up (they certainly cannot go down much farther), what should one own?

Real assets and companies that can withstand and benefit from inflation over the long term are good options. Examples include companies with popular, everyday products, like Johnson & Johnson (NYSE: JNJ), Cadbury (NYSE: CBY), Clorox (NYSE: CLX), Kimberly Clark (NYSE: KMB), and Molson Coors (NYSE: TAP).

Another opportunity might lie with companies like Automatic Data Processing (NasdaqGS: ADP), which processes payrolls and earns float on the overnight deposits. As interest rates rise, so will ADP’s profits. Payroll processors might experience a dip in volume as layoffs and bankruptcies spread, so investors must consider that risk. Other ports in an inflationary storm usually include real assets like oil, coal, steel, lumber, copper, and gold.