11 Inflation-Proof Financial Stocks

Story updated to include Bank of New York Mellon

NEW YORK ( TheStreet) -- We aren't officially seeing inflation yet, but inflation is something sophisticated investors have been wagering on for several months .

In general, that is bad news for financial stocks because most of their assets are take an immediate hit, according to Dick Bove, analyst at Rochdale Securities.

"The average bank balance sheet is comprised of just 5% in hard assets--buildings, equipment, etcetera. The other 95% are typically in some financial instrument," Bove says.

Bove says bank earnings "exploded" in the inflationary 1970's, stocks tanked as investors demanded ever-lower price-to-earnings multiples before they were willing to invest.

One of the big reasons for the run-up in commodities prices and related exchange-traded funds like GLD ( GLD) and SLV ( SLV) is that investors see commodities as having a finite supply. Dollars, by contrast, are under no such constraints, as the Federal Reserve demonstrated recently by announcing its intention to print $600 billion to buy U.S. Treasury bonds in a long-anticipated second round of quantitative easing, better known as QE2

Economics 101 tells us that increasing the supply of something is an excellent way to make it lose value. More dollars in the financial system would seem to raise a real inflationary threat, even though it may be offset by a still-weak economy. That's a big reason why investors have been piling into gold and other commodities, as well as currencies expected to remain more stable than the U.S. dollar. Many currency strategists expect the dollar's weakness to continue over the next 12 months or more, even though it has shown strength of late amid renewed fears over the European debt crisis.

Common measures of inflation like the Federal Reserve Bank of Cleveland's median consumer price index (CPI) and the core CPI from the U.S. U.S. Department of Labor of roughly one percent suggest inflation is not a threat, but those measures could change very quickly, which is what commodities and currency investors are betting will happen.

Inflation of the kind seen in some third world countries, where prices on items in the grocery store go up literally every day, is not a legitimate threat, according to Mike Cosgrove, principal at Dallas-based analytics firm The Econoclast.

"But the idea of returning to inflation of, say, five or six percent is certainly feasible, and the politicians, Congress--they have a vested interest in higher inflation," Cosgrove says, pointing out that it would enable them to pay down the ballooning U.S. deficit more easily by using "cheaper dollars."

With its $600 billion bond buying program, the Fed has monetized nearly half the federal deficit, Cosgrove says. The U.S. Congressional Budget Office estimates the 2010 federal deficit at $1.3 trillion.

Five or six percent would likely hurt most financial stocks, though they thrived in the middle of the last decade while inflation was at three percent, above the Fed's two percent target. And even if you think another boom in financials is unlikely, the sector is sufficiently beaten up that it may not need a boom for it to outperform.

The safe way to play financials, then, might be to own some stocks likely to weather inflation better than others in the sector. Here are some ideas:

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11. Bank of New York Mellon ( BK)

Bank of New York Mellon's ( BK) has outperformed peers like State Street Corp. ( STT) and Northern Trust ( NTRS) in recent days, helped in part by a big investment from Berkshire Hathaway ( BKR-B), disclosed in the conglomerate's latest 13F filing. Still, the bank would have lots to gain from a higher interest rate environment.

Bank of New York Mellon is one of the top securities lenders globally, and that business is priced off of short term interest rates. With those rates at historic lows, the bank can only charge miniscule rates to its customers in this area. Similarly, Bank of New York Mellon's money market business gets hurt by low interest rates because, like many other money management firms, it chooses to waive money market fees to ensure clients don't end up with a negative return on money market accounts. Maybe most important, though, is the massive pile of cash sitting idly on Bank of New York Mellon's balance sheet. Higher interest rates would allow the bank to earn higher returns on that cash.

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10. Goldman Sachs ( GS)

Goldman makes money in every environment, and they already appear to have been thinking about inflation in their decision to raise $1.3 billion via a 50-year bond sale last month. The 6.125% rate Goldman is paying will look awfully good if rates rise for an extended period.

Goldman has regularly shown special ability to get macro calls right, most notably during the latest crisis, when they cut way back on issuing subprime mortgage-related securities before the bubble burst, while also hedging much of their exposure. The feat allowed Goldman to outperform all of its major competitors, even if you are in the camp that argues the firm would be toast but for the help of the federal government.

Rochdale Securities analyst Bove questions whether Goldman would still be able to position its trading desks to make money from a surge in inflation. He argues such a move might be in violation of new restrictions on proprietary trading that were part of Dodd Frank financial reform legislation earlier this year. However, since those rules, like many others, still need to be clearly defined by regulators, "the answer is that nobody knows," what Goldman will be allowed to do, Bove says. Still, if we see a bout of inflation, it's hard to believe Goldman won't find a way to outperform its peers, as it so often does.

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9. Northern Trust

Northern Trust has a large cash position, meaning inflation and rising interest rates would enable it to earn more money on that cash. Management has said the low rate environment costs it about $70 million per quarter versus what it would earn in a more normal rate environment, according to a report from Sandler O'Neill analyst Jeff Harte.

Harte's report states that the low rates impact Northern Trust's net interest margin (NIM)--the difference between its interest expenses and the investments it makes, typically via loans. Northern Trust's NIM declined by .03% to 1.47% in the third quarter versus the second quarter. Also negatively impacted are money market fees Northern Trust charges to clients in its wealth management business, which it refers to as Personal Financial Services. As a result of the low yields on money market funds, Northern Trust has chosen to waive those fees, which cost it $12.9 million in the third quarter, according to Harte's report.

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8. American Express ( AXP)

Banks make loans to companies and home buyers that don't get repaid for several years. That's a problem for them if we have inflation, because they get paid back in ever-cheaper dollars. American Express doesn't have this problem, as its loans are very short term. What's more, American Express's biggest source of revenue is not from credit, but from fees it charges to merchant when customers use their cards. While new legislation know as the Durbin Amendment aims to reduce the amount of money banks make from merchants, the law targets debit card transactions, which American Express doesn't issue.

American Express also benefits from the fact that most of its growth is in overseas markets that aren't likely to be impacted by inflation. Overall, the picture is improving for American Express as its high-end clients upped spending by 14% in the latest quarter, according to a report from GimmeCredit. American Express earned $1.1 billion in the third quarter compared to $640 million in the third quarter of 2008, while loss provisions fell to $373 million from $1.2 billion a year earlier.

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7. Automatic Data Processing ( ADP)

Better to owe money than have it owed to you if inflation increases. Better still to provide services, the price of which you can hike if you need to. Among payroll and human resources processing companies, ADP has historically demonstrated strong pricing power, according to David Togut, analyst at Evercore Partners.

Togut notes ADP has 90% client retention in its payroll services business. It also offers tax filing services in which it essentially holds in escrow its customers' local, state and federal payroll taxes. They reinvest those taxes in conservative fixed income instruments across a broad range of maturities. ADP also can fund itself if needed in commercial paper markets to make tax payments if it proves more advantageous from a balance sheet management perspective.

In other words, Togut believes ADP has flexibility to handle either a rise or a fall in interest rates. If rates go up, they can reinvest short-term money at higher rates. While those benefits would be offset by higher borrowing costs in commercial paper markets, it means ADP is essentially hedged against interest rate moves. Still, rising rates would help on the margins. Togut says every 0.25% increase in either the Federal Funds rate or the Treasury yield curve as a whole increases ADP earnings by a penny per share. A 0.25% decrease causes earnings to fall by a penny.

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6. Citigroup ( C) gets a far higher percentage of its revenues abroad than big bank competitors like Wells Fargo ( WFC) or Bank of America ( BAC). That could prove to be a good thing if the U.S. sees major inflation, because Citigroup will get paid in stronger currencies outside the U.S. for business it does in those places.

Citigroup retail banking chief Manuel Medina Mora told investors this month that the bank is already in 120 of the 150 cities in the world it has identified as "top priority." Together, those cities account for 30% of global GDP, and just 34 of them cities are in the developed world. Though those 34 cities make up 50% of the GDP generated by the top 150, that ratio is expected to shrink exponentially in the coming years.

Citigroup has also been chasing institutional opportunities abroad, providing services including lending and back office functions to hedge funds, as one example. Increasingly whatever happens in the U.S. will mean less and less to Citigroup, especially in relation to its peers.

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5. Hartford Financial Services Group ( HIG)

Life insurers in general are a solid inflation play. Again, the theory here is that it is good to owe money if you have inflation because you will be able to pay your debts back in cheaper dollars. A $1 million payout on a life insurance policy sounds a lot better today than it will in 10 years if we average 5% annual inflation over that time. Meanwhile, the life insurers get to reinvest the premium payments they receive from policyholders at a higher interest rate in the bond markets as interest rates rise.

In the case of The Hartford, though, there is an another reason for investors to be bullish. The company has been punished ever since the dark days of Sept. 2008 because of big exposures they have to equity-linked life insurance policies. The policies guarantee a minimum return. The return lags the stock market if the market performs well, but are obviously nice to have if the market goes down. Insurers that sell these policies don't typically lose money on them if there is a mild selloff, because they hedge against that risk. However, if there is a dramatic selloff as we saw in the Fall of 2008 and again in February and early March 2009, such hedges become extremely expensive. If you believe those "buy a shotgun and stock up on canned food" days are behind us, The Hartford ought to recover some of the ground it lost relative to the rest of the sector.

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4. State Street Corp.

State Street is similar to Northern Trust in that it has lots of cash sitting idly on its balance sheet that it would like to reinvest at higher rates. Inflation would allow the company to do just that.

Another reason to be excited about State Street is that it has consistently been one of the largest holdings of Todd Combs , a hedge fund manager few had heard of until reports surfaced last month that he had been picked to take over a portion of Berkshire Hathaway's investment portfolio whenever 80 year-old investing legend Warren Buffett decides he's had enough.

State Street also benefits from being the most globally-diversified of the trust banks, an advantage Goldman Sachs analysts noted Nov.5 when they issued a report calling it their top pick in the group. State Street shares have essentially moved sideways since that time, so there's no need to wait to jump in.

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3. Comerica Inc. ( CMA)

Comerica has made a lot of loans with interest rates that adjust upward in a rising rate environment, according to Scott Siefers, analyst at Sandler O'Neill. Comerica should also be able to keep paying low rates on deposits to its customers even after Treasury yields have climbed.

"They've got a lot of core customers who are not necessarily going to jump immediately if their interest rates don't rise overnight," Siefers says, adding "it's pretty well known that if rates rise, Comerica is one of the primary beneficiaries among regional banks."

Data from SNL Financialbear this out. Among banks with at least $50 billion in total assets, has the highest one-year repricing gap, suggesting it is the best-positioned bank in the group for a rise in interest rates. To arrive at that figure, SNL subtracts interest-sensitive liabilities repricing within a year from interest-sensitive assets repricing within a year. The one-year gap ratio is that amount divided by total assets.

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2. MetLife ( MET)

Like other life insurers, MetLife would benefit from gradually rising rates because it could pay policyholders in cheaper dollars, while earning higher returns from investing premium payments it receives. It would also help with pension liabilities--again, because it would enable them to be paid in cheaper dollars.

UBS analyst Andrew Kligerman estimated in an August research report that pension-related expenses could drop by some $200 million by 2012 if rates rise and equity markets improve. Postretirement benefit costs for MetLife were $461 million in 2009--more than four times what they cost the insurer in either of the two previous year, according to Kligerman's research.

MetLife also hedges interest rate risk, and closely matches assets and liabilities, according to Kligerman. Also, its acquisition of American Life Insurance Co. from AIG dramatically increases its global footprint, which would provide protection against inflation in the U.S. Kligerman also wrote the acquisition will reduce MetLife's interest rate exposure by increasing revenues from accident and health insurance, which he writes are "underwriting margin driven" as opposed to being interest rate sensitive.

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1. Lincoln National ( LNC)

Like the other life insurers, Lincoln would be able to earn higher returns on its bond portfolio if rates rise gradually. A sudden surge in interest rates, however, would hurt life insurers because they wouldn't be able to reinvest quickly enough to offset the drop in value of longer-term bonds they currently own.

However, while other insurers, such as MetLife, are better protected against an extended low rate environment, Lincoln National is perceived by the market as being more vulnerable in this area. UBS analyst Kligerman believes Lincoln National would clearly suffer if rates remain low for another two years. However, if you don't think such a scenario is likely, Lincoln's stock appears spring-loaded for a rebound if rates begin rising.

Lincoln has also a $125 million share repurchase authorization over the next 15 months and may buy back additional shares if the economy stabilizes and earnings outpace expectations, according to Sandler O'Neill research.

>To see these stocks in action, visit the 10 Inflation-Proof Financial Stocks portfolio on Stockpickr.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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