Prepare for the Inflation Fight Now

As emerging markets beef up efforts to curb inflation, stocks there are likely to suffer. Now is a great time to look closer to home.

Inflation looks like the biggest story of 2011 for investors.

It's not. The success or failure of government actions to fight inflation is the biggest story of 2011.

What's the difference?

If inflation were the story, you all know what I'd be telling you to do. Buy gold, silver, and platinum (and the shares of the companies that mine those metals). These and other inflation hedges will rise in price as the real buying power of money falls. Buy the shares of commodity producers because what they dig or pump or wash out of the ground is itself a great inflation hedge, and the profits of these producers will rise as the real value of money falls.

But that's not such great advice if 2011 isn't going to be the year of inflation. In retrospect, 2010 may get that crown—and 2011 could be the year of the inflation fight.

If the fight against inflation is the story for 2011, investors can expect waves of worry to sweep the financial markets of the economies that are on the front line of that fight: China, India, Brazil, and other emerging nations. Fears that governments will raise interest rates, increase bank reserve requirements, or slap on currency controls will send stocks down in those markets. And because these emerging economies are currently the drivers for global growth, lower stock prices there will frequently push down markets around the globe. To see the likely result of these worries, just look at China's Shanghai Composite Index, which finished down 13.4% for 2010.

Get Ready for a Heck of a Fight

What's a good strategy for a “fight against inflation" market? To explain that, I'll start by describing where we are in that fight and how the battle will develop this year.

Based on the evidence so far, the fight against inflation is going to be a real barnburner. Inflation has gained a strong foothold in the world’s emerging economies, and big efforts will be needed to tame it.

In China, inflation was running at an annual rate of 5.1% in November. The rate is expected to have fallen to 4.8% in December, but that is still well ahead of the government's target—even after it raised that target to 4% in 2011 from 3% in 2010.

In India, the benchmark wholesale price index accelerated to an annual 8.43% in December, up from 7.48% in November. The big driver is higher food costs. The price of onions, for example, spiked up 70% in the week that ended Jan. 1. (See my Jan. 14 column “Profit from Soaring Food Prices”.)

In Brazil, not only is inflation heading higher, but expectations for inflation in the future are also surging. Economists who last week had been predicting a 5.34% inflation rate for 2011 have now raised their forecast to 5.42%. Inflation ran at 5.91% in 2010. The government put its target rate for inflation at 4.5% in 2010 and 2011.

Inflation isn't running wild everywhere, though. It remains under control in the world's developed economies. The European Central Bank has flashed a "danger" sign on inflation in recent days, but inflation in the European Union was running at an annual rate of just 2.2% in December. (This is the first time in two years that inflation has run ahead of the bank's target of just below 2%.)

Headline inflation in the United States ran at a 1.5% annual rate in December; the Federal's Reserve's preferred core inflation number, which excludes food and energy prices, was at just a 0.8% annual rate. And in Japan, inflation was a barely measurable 0.2% annual rate in November.

NEXT: Turmoil in Emerging Markets Is Coming

Turmoil in Emerging Markets Is Coming

As you'd expect from these numbers, the world's emerging economies are where governments are most engaged in fighting inflation. China has raised its benchmark interest rate twice and its reserve requirements for banks four times in the last six months. The Reserve Bank of India has raised its benchmark repurchase rate six times in a year and is expected to raise it again this month to 6.5%. In Brazil, interest rate futures indicate that markets expect the new central bank president, Alexandre Tombini, to raise the benchmark Selic rate by 0.75 percentage points, to 11.5%.

These actions have taken a whack out of the stock markets in each of these countries. Shanghai, as I've noted, ended 2010 down 13%. Brazil, as measured by the iShares MSCI Brazil Index ETF (EWZ), was up 7.6% in 2010, but that's just half the return of the US Standard & Poor's 500 Stock Index—even though the Brazilian economy grew by a projected 7.5% last year. India's BSE Sensex 30 Index finished flat from October to December 2010. (For more country comparisons, see my column "World's Five Best 2011 Stock Markets.")

The scary thing now is that rate increases haven't been enough to convince investors that the emerging economies will ultimately win the inflation battle.

For example, yields on China's ten-year bond are moving up, while yields on its two-year note are falling. The spread between the two grew to 0.71 percentage points on January 18, up from a 0.8 percentage point spread on January 4. That kind of increase in the spread between shorter- and longer-term bonds is exactly what happens when worries about future inflation are increasing.

In Brazil, the yield gap between inflation-linked and fixed-rate bonds now indicates that inflation will climb to 6.5%. And the futures market is projecting that the central bank will increase interest rates to 13.25% in 2011. Not so long ago, economists were projecting that interest rate increases would stop at 11.75% or 12%.

Financial markets expect that central banks and emerging economy governments are going to have to take far more drastic steps than they've taken so far to get inflation under control. In Brazil, financial markets seem to be looking for the new government to demonstrate its resolve through spending cuts. In China, it appears that it will take increases in benchmark interest rates of another 1.5 to two percentage points to soothe investors.

Those governments would prefer not to go as far as the markets are now suggesting. After stimulating their economies to escape the global Great Recession, governments from China to Brazil don't want to give up hard-won growth in the fight against inflation. That's why so many of the moves announced so far have been what I'd call gimmicks—currency controls, increases in bank reserve requirements, tougher mortgage standards, etc. It seems that these countries are hoping to win the fight against inflation on the cheap.

I doubt that such efforts will work. They don't go to the heart of the problem—runaway lending and money-supply growth—that are the result of a mix of stimulative domestic policies and hot-money flows from the US, where the Fed is still conducting monetary easing.

As long as these measures don't work and don't get inflation under control, emerging economy financial markets won't be able to relax. Every announcement of strong economic growth will be treated as mixed news, because higher growth raises the odds of higher inflation.

NEXT: Why the US Could Be a Safe Haven

US Markets Could Prove a Safe Haven

This scenario is why the consensus wisdom on Wall Street is that US financial markets will outperform many emerging markets again this year. US growth at 4% or so won't be higher than growth in China, India, or Brazil. But with the US Federal Reserve on hold and inflation in the Unites States so restrained, US markets don't need to worry about interest rate increases that might slow the economy.

It's also why the consensus call is to move out of shares of commodity producers and other companies that depend on demand from China and other emerging markets.

If you believe that 2011 is the year of fighting inflation—and I do, just to be perfectly clear—you ought to trim any commodity and emerging-market positions now. Rebalance your portfolio to emphasize US stocks. And you ought to do it now.

Like most consensus calls with an ounce of wisdom in them, the current preference for US stocks over emerging-market equities will run to excess. Soon US stocks will become relatively more expensive, and emerging market stocks relatively cheap. Investors will forget that we're talking about a fight against inflation that isn't going to wipe out growth in emerging markets or all increases in commodity demand.

The World Bank predicted on January 12 that China's economy, for example, will grow at just 8.7% in 2011, down from 10% in 2010, because of efforts to fight inflation. Thanks to those same inflation-fighting efforts, global copper demand will slow to 6% growth in 2011 from 10% in 2010, according to Macquarie Group.

That doesn't sound like a recession to me—either in China or in commodities. But I wouldn't be surprised if investors' emotions have swung so far toward pessimism by sometime in 2011 that they're selling emerging-market and commodity stocks as if it were a recession. When that happens, I'd prefer to be buying, rather than selling into that pessimism.

In the meantime, if you need to include markets outside the US in your portfolio, look for ones that are sheltered from the worst of the fight against inflation, show good growth prospects, and look relatively cheap on those growth prospects. I suggest Mexico, Poland, and European markets, such as Italy. I'll have some more detailed ideas for investing in those markets in coming weeks.

The mutual fund Jubak manages, Jubak Global Equity Fund (JUBAX), may or may not now own positions in stocks mentioned in his columns. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund's portfolio here. He will have the fund's portfolio as of the end of December posted in a few days.