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Andrew Allentuck

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When prices rise, own the problem

Andrew Allentuck

Inflation is the enemy of capital markets. In small doses that's when the Consumer Price Index is rising at just a few per cent a year inflation is a gentle

stimulus for the economy, reducing the real cost of debt and adding a few more

nominal dollars to paychecks each month.

When inflation heads into the double digit range, it becomes a massive danger to corporate profits as it raises debt services charges and reduces profits. But one part of capital markets tends to thrive when inflation is roaring commodities. The reasons are

straightforward: first, the prices of steel and aluminum, orange juice, lumber, and oil are

built into the components of the Consumer Price Index. Labour and services are in the CPI as well. But commodities are at the core of the definition of the CPI and are as well among its most volatile components. After all, if you take energy and food out of the CPI,

it becomes downright meek.

Today, the hottest stocks in the U.S. and Canada are commodity producers: oil and gas companies, gold miners, potash miners, rare metals and materials companies,

and businesses leveraged on agriculture like implement makers, grain shippers, and farm chemical concerns.

There is a good chance that rising energy and food prices will spark higher inflation rates around the world. Already, this year, crude food prices have risen 26 per cent. Finished consumer foods are up almost 7 per cent. The shift of consumer tastes in China from vegetables to meat will add to food prices pressures, for it takes several pounds of feed to make a pound of meat, the ratio depending on the animal, of course. Add to that the artificial boost to prices of grain that has been generated by the U.S. policy of subsidizing production of ethanol from corn and one can see a strong inflationary boom in agricultural commodities for years to come.

"You have to distinguish commodities that are good inflation hedges from those that are not," says Martin Anstee, vice president and portfolio manager at Stone Asset Management. in Toronto. "If you are in a period of stagflation, the industrial commodities will not do well. That's because demand for metals will be down. But gold would be up as an inflation hedge. Under inflation with no stagnation, then all commodities can thrive. "If inflation goes from low single digits, which is good for business and may even stimulate people to spend a little more, to double digit inflation, which causes companies to have to pay high debt service charges and to have less money for dividends, then you would want to buy commodities. Right now, for example, the price of oil has risen faster than the value of oil stocks. For now, commodity prices look like they will continue to rise. And energy, which is hard to cut back on in the short run,

Still looks like it can do well until it has a negative impact on the real economy and demand for energy begins to decline."

The one sector of the economy that is most likely to thrive with rising inflation rates is commodities. In the past, stock prices and commodity prices were inversely correlated or even uncorrelated. But since 2000, the S&P 500 Composite and the Industrial Metals Index have shown a strong positive correlation. They have both reflected growing global markets, though the metals index has actually been the superior play. It fell less than the S&P 500 during the 2000-2002 tech bust and rose by a good deal more than the Composite since then.

There is a clear potential for inflation to rise, even if economic growth slows.

The combination of slowing growth and rising prices, stagflation, would tend to clobber

corporate profits. Investors will tend to flee from sectors like retailing, food distribution,

and automobile manufacturing. Money is likely to head to commodities.

But which commodities and which companies? As Jackee Pratt, vice-president and portfolio manager for Mavrix Fund Management Inc. in Toronto notes, "macroeconomics is one universe and capital markets are another." In other words, there is more to the price of a stock than sector analysis. Profit margins, debt to equity ratios,

dividends coverage, price to earnings ratios and other measures of corporate performance, not to mention the investor's trading skill, drive investment returns as well.

A strong market trend can make most of those measures look good. Thus continuing declines in the U.S. dollar will tend to drive up the price of gold and gold mining stocks as investors rush to hedge the declining values of their American equity portfolios. Energy stocks too should thrive.

Don Short, president of Origin Capital Management in Calgary and portfolio manager of the OCM Energy Total Return Fund, says "it makes sense to buy energy stocks to hedge increases in the cost of living. After all, energy is used in food and transportation, manufacturing and home heating." His picks for energy stocks are companies with reserves that have long lives, that don't have too much debt on their balance sheets, that have not crippled their profit margins with forward sales and that have proven management. "Buy senior companies so that you are not taking exploration risk," he advises.

But beware the volatility of commodity stocks, says Pat McKeough, publisher of Toronto-based newsletter The Successful Investor and a portfolio manager. "Commodities have broken out of a decades-long slump and are rising," he says. "They should be part of every investor's portfolio, but they will remain volatile."

Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.

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