Despite what you might read about the perils of inflation, a small increase in prices isn't necessarily a bad thing.
Investors have become as concerned about inflation as they were about deflation early last year, and expectations for aggressive interest rate hikes have shot up. Bond investors worry that inflation will eat away at the value of future fixed-income payments; equity investors fear that it will reduce the value of future earnings.
Still, rising inflation has an upside: It can allow some companies to raise their prices and actually increase profits. The trick is finding those companies.
While inflation has been accelerating this year, price increases haven't been as broadly based as one might think. A consumer price index based simply on discretionary items like restaurants, alcoholic beverages, household furnishings, apparel, new and used vehicles, airfares, recreation, IT hardware/services, personal care goods and products and services, actually fell in May at a year-over-year pace of 0.4%, according to Merrill Lynch.
In contrast, basic necessities like food and energy have seen sharp price increases. A CPI based on "mandatory" components like fuels and utilities, motor fuel, groceries, public transportation, medical care and education, rose 1.3% in May, taking the year-over-year trend in this category to 6.8% from 4.9% in April.
Just because a subelement of the CPI is rising doesn't mean the provider of that good or service is making more money; input costs could be going higher. But Chris Casey, a portfolio manager at Boston Private Bank & Trust Co., said many of the sectors showing inflation also have strong pricing power.
"We think that when something filters through to the CPI, it gets into consumers' heads," he said. "Once consumers believe there's inflation out there, then they're more apt to accept higher prices and that gives companies pricing power."
Casey likes oil and gas companies like
Pioneer Natural Resources
. Oil prices have been driven up this year by strong demand from Asia, tight supplies from the Middle East and geopolitical concerns, and Casey believes the trend will continue.
Other analysts say medical companies should continue to benefit from rising prices. Steve Neimeth, a large-cap fund manager at AIG SunAmerica Mutual Funds, likes
"HMOs continue to have the ability to raise pricing, albeit at a lower rate than in the past," he said. "The fundamentals are still very favorable for HMOs."
Although managed-care providers have been limiting the increase in health care insurance premiums this year, most premiums are climbing at several times the rate of inflation, according to
The Wall Street Journal
Tom McManus, chief equity analyst at Banc of America, has been advising clients to "double-weight" companies that he believes will be able to raise prices this year without hurting market share. He particularly likes supermarket
Over the past couple of years, supermarket chains have suffered from
entry into the food business, and many firms have been forced to slash prices to remain competitive. But McManus said Wal-Mart is now starting to pursue a "margin protection strategy" that should bode well for supermarket chains.
Analysts note that some of the biggest beneficiaries of rising inflation this year could be those previously considered victims of disinflation, or declining inflation. McManus said paper stocks such as
fall into this category (Banc of America has had a banking relationship with Safeway, International Paper and Boise in the past 12 months.)
Global demand for commodities and basic materials is expected to remain strong this year, particularly in Asia. "Even though China is slowing, it's still showing incredible growth," said Casey. "We're still bullish on ... copper, gold miners and the steel companies." (Casey owns Devon and Pioneer Natural Resources).
Even retailers such as
could see some better pricing activity going forward, according to Neimeth, who in his fund owns all the stocks he mentioned.
"These companies, which over the past few years were faced with a deflationary environment where consumers were demanding lower prices, for the first time have the ability to raise prices" by reducing markdowns, he said.
While rising inflation can actually be a good thing for corporate earnings, it's not hard to understand why investors are so nervous right now. After all, higher inflation often leads to higher interest rates, which can ultimately compress price-earnings multiples. The
is widely expected to raise rates by 25 basis points at the end of this month and investors are pricing in 125 basis points of tightening by the end of the year.
"Some areas of the market can overcome P/E multiple compression, especially if pricing power is evident," said McManus. "
But the anticipated tightening raises doubts about the sustainability and breadth of the earnings recovery."