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By David Baskin

As recently as last summer, the Chairman of the U.S. Federal Reserve Bank, Ben Bernanke, was giving speeches warning of the dangers of deflation. Don’t worry, he told us, the Fed has the tools to combat falling prices, and sure enough, in late autumn he rolled out QE2, the massive $600 billion intervention in the bond market intended to reduce long interest rates and flood the money markets with liquidity.

Four months later, the results are in. On the one hand, the Fed has failed. Long interest rates are rising in the U.S. and pretty much everywhere else in the world. On the other hand, no one is talking about deflation anymore. Instead, the headlines are all about rising inflation. From being off the radar screen last year, suddenly inflation looks like an oncoming, perhaps unstoppable, freight train.

We have not had much experience with inflation in North America over the past quarter century. The brutal recession of 1981 crushed inflation with enormous interest rates (prime rose to 22.5% in Canada) and the resulting very high unemployment, well over 10% in both Canada and the U.S. For the subsequent 25-year period from 1983 to 2008, the inflation rate in Canada rose by only 2.7% per year. Contrast that with the previous decade: Prices from 1973 to 1983 rose by 9.5% per year, and inflation peaked at 12.5% in 1981.

The numbers above are abstract and hard to absorb, but here is a more concrete way of looking at the impact of high inflation on everyday prices, over a 20-year period:

Inflation distorts everything. As prices become more fluid, consumers become uncertain about purchases and the value of goods and services. Salaries rise, but employees find that they can’t buy as much as they used to, even with their bigger paychecks. Companies’ earnings look better simply because old inventory rises in value.

As with every economic change, there are winners and losers. The big losers in times of higher inflation are those who have contracted for a fixed sum or set of payments stretching over years. Holders of life insurance policies, for example, will upon their demise leave their heirs with a lower real value of benefits than what they had planned. Pensioners and owners of annuities who receive a monthly check will find that it buys less and less as time goes by. Owners of bonds will discover that the interest they are paid is much less than that paid on newly issued bonds, and that the value of the principal is moving inexorably lower every year. Companies that lack the ability to change prices quickly – whether because they are subject to regulation or because they have entered into long-term fixed price contracts – will find themselves falling behind the inflationary curve.

The winners are owners not of obligations, but of real things. Real estate tends to rise in value with inflation. So do most commodities: Oil, metals, timber, and food stuffs. Companies that have pricing power also rise in value, as they ride the inflationary wave to ever larger revenues and profits.

Consumer price inflation is not yet a real problem in Canada, but we foresee it becoming one in the next year or so. We have told our clients that 2011 is a hiatus year, one in which we can prepare our portfolios for what we see coming in 2012 and beyond. To this end, we will be reducing some of our long-time holdings in pipelines, utilities and telecommunications firms. These companies are under the control of regulatory bodies which can be slow to react to changing circumstances and which are frequently subject to political pressure, as we are currently seeing in the dispute over fees for Internet use. Moreover, the dividends which have made these stocks so attractive in the current era of low interest rates will become less compelling as interest rates rise.

We will be increasing our holdings in the areas we have identified as likely winners in the inflation game: Government Real Return Bonds, which have their value adjusted by the increase in the Consumer Price Index; Real Estate Investment Trusts (REITs), which benefit from increasing rents, increasing real estate values and which still receive favorable tax treatment; and companies that produce or deal in commodities.

We do not anticipate inflation reaching the disastrous levels we saw in the late 1970s and early 1980s, but we do think it is prudent to plan for a decade of inflation in the 5% to 7% range – that is, much higher than we have had in a long time. There is not too much downside, in our view, of making these changes in asset and sector allocation, but there could be a substantial risk in remaining complacent in the face of what we see as real and substantial change.

Source: A Strategy to Prepare Your Portfolio for Inflation