Related topics: China, Brazil, Europe, investing strategy, Jim Jubak
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 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.
Jim Jubak
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 fell to 4.6% in December, but that was 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 70% in the week that ended on January 1 (See my column on how you can 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.
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 point, 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 (EWZ), was up 7.6% in 2010, but that's just half the return of the U.S. Standard & Poor's 500 Index ($INX) -- 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 5 Best Markets for 2011.")
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 10-year bond are moving up, while yields on its two-year note are falling. The spread between the two grew to 0.71 percentage point on Jan. 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.
