Image: Inflation © Nick Koudis, Getty Images

Related topics: China, Federal Reserve, economy, investing strategy, Anthony Mirhaydari

A few months ago, I suggested that what we needed to cure our ailing economy was a dose of inflation. Not too strong a dose, but one strong enough to give the economy a swift kick in the rear.

While calling for inflation seemed like a terrible idea to many, there were a number of solid reasons to root for it: Higher prices would get companies spending on new equipment and employees, would push the stock market higher as cash flowed out of bonds and would encourage banks to start lending again. And for the most part, all of this has happened.

I wasn't alone, either. Federal Reserve Chairman Ben Bernanke was warning about the risks of falling prices and the creation of a Japan-style debt deflation death spiral during this period. He wanted to print more money to prevent it. This was the subject of a column I wrote back in August. Obviously, inflation staves off deflation.

But by the time the Fed got around to announcing its $600 billion "quantitative easing" money-printing operation back in November, the risks of deflation had passed and inflationary pressures were starting to build. The extra jolt of monetary stimulus sent prices skyward. It was too much. This was also discussed in one of my previous columns.

Image: Anthony Mirhaydari

Anthony Mirhaydari

Now, with food and fuel prices soaring -- crude oil is creeping toward $100 a barrel, while the United Nations' Food Price Index recently moved to an all-time high -- the risks have flipped to the other end of the spectrum. Now, excessive inflation is the bigger threat.

In fact, I've gone from rooting for inflation to being scared of it. It's going too far.

Here in America, prices are rising at rates not seen since early 2009. China's inflation rate hit a 28-month high of 5.1% in November. European prices jumped at a 2.2% annual rate in December, above the European Central Bank's 2% target. And in the United Kingdom, prices increased at a 3.7% rate in December after increasing a record 1% on a month-over-month basis.

As a result, and with investor sentiment at levels not seen since 2007, the stage is set for a period of weakness in the financial markets over the coming weeks as investors react to this concern. While I still believe we're in just the middle innings of a long-term bull market, the next few months could be very rough. Let's look at the reasons why.

Rises and riots

Inflation is spreading across the globe like a cancer.

In Africa and the Middle East, political turmoil driven by rising food prices has resulted in the ouster of Tunisia's president and protests in Algeria and Mozambique. The threat of food inflation has also sent leaders in Libya, Jordan, Morocco and elsewhere scrambling to keep prices down and their citizens off the streets. New demonstrations against economic hardships have appeared in Egypt and Mauritania.

In emerging markets, India's government is struggling to find a solution to a tripling of onion prices, Mexico has hedged against a rise in tortilla prices, Indonesia is grappling with a huge rise in chili-pepper prices, and China is contending with more-expensive cooking oil. Tension is in the air. India's shop owners, accused of speculative hoarding, have gone on strike in disgust. China has released cooking oil from its strategic national reserves in Xinjiang and Shandong. Indonesia's president has proposed that people start growing their own chilies in flowerpots.

These price pressures are extremely dangerous for a global economy still on the mend. With governments around the world tightening their budgets, the only source of new stimulus was from monetary authorities. Inflation takes that source of support away -- and could even set it in reverse.

Indeed, European Central Bank President Jean-Claude Trichet said he wouldn't hesitate to raise rates if inflationary pressures continue, despite the fact that troubled eurozone countries, including Ireland and Portugal, continue to depend on the central bank for support. In a recent news conference, Trichet made frequent references to his decision to raise rates in July 2008 in the midst of recession out of concern for rising commodity prices.

While in hindsight most think this was a mistake, Trichet brandishes the move as a sign of his commitment to fighting inflation above all else.

There's more. China last week increased the amount of reserve banks are forced to hold. It's the seventh such move since the beginning of 2009, and it comes in the wake of a surprise interest-rate hike in December. Thailand, South Korea, Serbia, Hungary, India and Australia also have raised interest rates recently, and more countries are expected to join in.

We've been protected . . . so far

Americans have largely been insulated from the global inflationary pressures that have accumulated over the last six months. But the problem is beginning to bite here. Gas prices have returned to levels that haven't been seen since 2008. And consumer confidence has taken a hit -- which will weigh on spending going forward. Yet the indirect risks are the greatest concerns.

There are two main problems. The first is the risk that emerging nations like China, which have already started raising interest rates to battle inflation, will be forced to drive their economies into the ground to keep prices in check.

The second is that the inflation hawks in Europe will shift their focus from bailouts to fighting inflation -- thereby tightening the noose around Greece, Ireland and Portugal and setting the stage for the first rich-country debt default since the 1940s. Tighter monetary policy and interest rate hikes will result in unsustainably high borrowing costs for those countries.

Blame the chain

Setting aside the problems with emerging markets and Europe, corporate America faces the prospect of reduced profit margins as higher inflation brings both cost increases and reductions in consumer demand. Right now, according to Credit Suisse researchers, cost inflation on such things as raw materials and labor wages is at the lowest level since tracking started in 1961.

But those costs are now set to move higher. And as they do, they will put pressure on earnings growth. That, in turn, will weigh on stock valuations and prices. Throw in the pressures from a likely eurozone bond default and the potential for a slowdown in China, and the stage is set for a meaningful correction in risky assets like stocks and industrial commodities.

The problem is that higher inflation is pretty much baked into the cake at this point. Deutsche Bank economist Joseph LaVorgna reminds us that inflation is a lagging economic indicator. Last summer's deflation scare was an echo of the sharp drop in economic activity from the beginning of 2008 to the middle of 2009. In the past, inflation has bottomed six to eight quarters after a recession has ended. That means prices should hit bottom and start turning higher sometime between now and the end of June.

Also, the inflation "pipeline" is fully stocked, with both import and producer prices rising much faster than consumer prices. In December, import prices jumped at a 4.8% annual rate, compared with a 1.4% rise in consumer prices. LaVorgna finds that both "exhibit a significant lead on consumer prices, particularly those for core consumer goods."

Time to prepare

So what can investors do in this environment?

My appeals to avoid bonds and cash while moving toward stocks still stand. Yes, risky assets of all types likely will suffer losses in the weeks to come as investors react to the increase in prices and the resultant withdrawal of ultra-cheap central bank financing. Nevertheless, equities are still the preferred investment at this point in the business cycle, offering protection against inflation, unlike bonds.

Image: Rising Inflation © MSN Money

You can see this in the chart above -- which compares the performance of stocks to bonds during the time of rising interest rates and inflation from the early 1950s to the early 1980s. Inflation rose from negative territory to a high of 14.8% over the period. Stocks outperformed bonds by a huge margin.

Image: Falling Inflation © MSN Money

Compare that with what happened during the falling inflation/falling rate period from the early 1980s to the mid-1990s, as shown in the chart above. Inflation fell from its high to just 2.7% in the period. Clearly, the performance disparity between the returns to stocks and bonds was much smaller. In fact, for a time in 2009 (not shown in the chart), the cumulative return to bonds over the period actually exceeded that of stocks as the inflation rate went negative again, pushing bond prices higher.

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That helps explains the recent obsession with bonds among retail investors -- along with the fact that stocks are exiting their worst 10-year performance since the 1930s.

So if you've been sitting on the sidelines, use the turmoil ahead to transition out of bonds and into stocks at a discount -- and avoid the next great 401k wipeout I warned about last week once the specter of inflation passes and Europe addresses its structural issues in a comprehensive way . Sure, there will be setbacks and volatility. But above all else, being in the right asset class will help you create wealth in the decades to come.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.