How To Stay Ahead Of The Inflation Curve

It isn't supposed to happen. The world is awash in overcapacity, wages are stuck in the mud, unemployment is high, and many prices are falling. Yet inflation shows signs of coming back.

Not in a big way--yet. Economists who had projected 3% inflation now expect 4% in 1993. And investors worry that interest rates have bottomed out and may soon rise. Even if you doubt inflation is imminent, it's not too soon to strategize. "By the time you see the whites of the eyes of the next inflation," says James Grant, editor of Grant's Interest Rate Observer, "the hedges will be highly priced."

When inflation strikes, rising prices rattle investors' faith in paper. They flee into tangible commodities such as gold, oil, and real estate. But this time may be different. For one thing, 4% inflation is a far cry from the double-digit days of the late '70s and early '80s. "Investors have to choose between a hurricane and a breeze strategy," says Dick Hoey, chief economist at Dreyfus. The signals point to an inflation breeze--a gradual lift in rates. "In these conditions, the stock market does O.K.," says Hoey, "because the earnings rise is powerful enough to balance the inflation rise."

ESCHEWING TOBACCO. Businesses that will be able to raise prices can benefit most from inflation. Industries that have downsized and are operating at tight capacities, such as steel, petroleum, and textiles, should fare well, says Hugh Johnson Jr., chief investment officer at First Albany. So should cyclicals, which rise as the economy improves. David Shulman, equity strategist at Salomon Brothers, recommends PPG Industries, Allegheny, and Plains Petroleum.

What to dump? Lighten up on utilities, which act like bonds, and consumer staples such as tobacco where price competition is stiff, says Shulman.

Bonds are the biggest casualty of inflation. As interest rates go up, holders who bought at low rates are stuck with shrinking returns. If you're not ready to sell, you can hedge with bonds. Switch from long- to short-term bonds so you can capture higher returns as rates rise, says First Albany's Johnson. Upgrade your holdings because inflation fears can harm leveraged companies. Buy coupon bonds instead of zeros, which don't pay interest that can be reinvested at higher rates.

Gold tends to shine when inflation heats up. Strong Asian demand has already driven gold prices up. To be on the safe side, you may want to dip a toe in. Dick Young, editor of Richard C. Young's Intelligence Report, advises readers to put only 10% of your portfolio into a gold fund at this early stage of inflation. "Buy it with the idea that you won't make any money," Young says. "Hopefully, your other assets will do well, but if they don't, you'll be damn happy you were in gold."

HOUSING TROUBLE. August Arace, who handles gold for John Hancock's Freedom Gold & Government Fund, recommends putting 5% of your portfolio into gold stocks diversified among solid North American mining companies. Gold stocks are more volatile than bullion and do better when rates rise.

Real estate is another tangible investment that soared in the '70s. But it will take longer to pay off this time, because the industry is swamped by overcapacity. "Housing has dramatically underperformed since the early '80s despite the lowest mortgage rates in years," says Gerald Guild, a fixed-income manager at Advest Group.

Some investors with deep pockets are finding returns down on the farm, says Jeremy Diamond, publisher of Grant's. Prime Midwest farmland, at rock-bottom prices, is paying 5% to 12% in rent from local farmers, a cut of the crop, or government subsidies to keep the land fallow.

Other commodities have a similar advantage. Silver and cocoa have been down so long, it may look like up for them. "To be an inflation-minded investor, you don't have to believe in new great inflation, just find out what's cheap," says Grant. That means taking a look at investments that are currently overlooked.

      CASH Rising money market and CD rates will boost yield. But initially rates may 
      not even keep pace with inflation.
         BONDS Move out of long-term issues and into short-term bonds.
         STOCK Look for companies with pricing power in cyclical 
      industries, such as textiles and paper.
         GOLD The @ld Faithful of inflation-hedges. Mining stocks are more volatile 
      than bullion, and so rise--and fall--faster.
         OTHER COMMODITIES Oil and gas, coffee, silver, grains, and other commodities 
      may not soar, but many are extremely cheap and potential good buys.
         REAL ESTATE It may take a while to pay off because over-
      capacity is still swamping the market.
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