street sense
Get Ready for a Return to Inflation
Big budget deficits, new government programs and large tax cuts will force interest rates higher in 2005.
By Jerry Helzner

If I'm reading the economic tea leaves correctly, inflation should begin to rear its ugly head again in early 2005. And since the stock market always reacts to future economic trends well before they're reflected in such measures as corporate earnings, now might be a good time to take action to protect your investment portfolio.

This month, I'll explain why another round of inflation is almost a certainty, and what steps you can take to preserve your assets.

If one were to describe a perfect recipe for inflation, its ingredients would include huge federal budget deficits, massive government spending programs to fund both social programs and a war, a sharp increase in the price of gold, and a rush of investment money into such basic commodities as oil, natural gas, copper and nickel.

In truth, all of these elements are already in place. If you want a parallel in history, Lyndon Johnson's Great Society of the the mid-1960s will do quite nicely. Johnson's attempt to fund both a war and a social agenda led to an increase in the prime interest rate to above 8 percent at the end of his term. The policies of the Bush administration are likely to have a similar effect on interest rates in the near future.

But if these key elements for higher rates are already in place, how are interest rates able to remain historically low? Good question.

It's an Election Year

Those who see no imminent threat of inflation point out that the economy is still sluggish and unemployment remains high. With so much slack in the economy, businesses are reluctant to raise prices and workers can't make wage demands. Hence, important elements of the "return to inflation" scenario aren't present.

That's a reasonable argument, but it's short-sighted. It doesn't take into account that 2004 is a presidential election year. The Bush administration is already pumping money into the economy at a furious pace with the goal of jump-starting an economic boom that will peak sometime around November. Not a bad plan for a president who's looking to be re-elected. Bush tax cuts are already having an effect. The Gross Domestic Product grew at an eye-popping 7.2% rate in the third quarter of 2003.

The Fed Won't Act

So let's fast-forward to early November. With a stronger economy, an even bigger deficit, and continuing tax cuts, it will be almost impossible to keep inflation down. And don't expect the Fed to raise interest rates during an election year.

Given all these factors, it will be early 2005 before any real action can be taken to tamp down these inflationary pressures.

Because I expect interest rates to be sharply higher a year from now, I suggest that you start now to lower exposure to interest-sensitive areas of your portfolio. That means cutting back on holdings of homebuilders, bank stocks, insurance companies, and, of course, reducing your exposure to bonds. To take their place, consider buying good energy and commodity-related stocks on dips.

And if you haven't refinanced your home mortgage yet, you should do it soon, while interest rates still remain relatively low.

I can't absolutely guarantee a return to inflation, but every party must end, and it looks more and more like the days are numbered for the environment of low interest rates that we've enjoyed for the past several years.

Ophthalmology Management Senior Associate Editor Jerry Helzner has written more than 50 articles on stock investing for Barron's. He has been a regular stock market columnist for other business publications and was a member of the equity research department of a major regional brokerage firm. E-mail your stock market questions to him at helznergi@boucher1.com