Hurricanes, energy and inflation

The past month has seen two tremendous hurricanes slam into the Gulf Coast, devastating many lives and causing billions in damage to infrastructure, property and energy facilities. After the initial shock of the storms impact, investors have begun to focus on the potential benefits of rebuilding the affected areas. However, another by-product of Katrina and Rita that may leave a nasty imprint on the economy and investment portfolios is the growing effect of inflation.

Even though many recent government reports have shown that inflation remains in check, daily events may indicate otherwise. If you spend a lot of time driving, pay for the bulk of your health care insurance, or have children in college, you are probably experiencing inflation first hand.

Companies that in the past enjoyed stable raw materials prices and increasing productivity are beginning to experience rising costs for energy, lumber and other basic materials. This in turn has forced some businesses to begin hiking the price of their finished product or service. Since inflation at any level will impact individuals' finances, it's imperative to understand how it affects you and how you can minimize its negative consequences.

For the most part, everyone understands and experiences inflation. A classic example is the gallon of gas that used to cost $0.50 in the 1970s now sets you back $2.75. Rising inflation can be caused by a number of issues including rising budget and current account deficits, oil and commodity price spikes, and increased government spending. All of these issues are currently at the forefront of today's economy and markets. With the potential rebuilding costs in the Gulf Coast region exceeding $200 billion over the foreseeable future, the need to try and keep inflation in check has increased.

One of the primary options at the disposal of the government to reign in inflation is to tighten the supply of money circulating through the economy. This is typically the job of Mr. Greenspan and company at the Federal Reserve. Their main tool to slow inflationary pressures is to raise short-term interest rates, thus reducing the flow of money into the economy by raising borrowing costs.

The Fed's recent rate hike, even after the economic disruption from Katrina and the potential impact of Rita, demonstrates the concern among policy makers that inflationary pressures persist. This is troublesome since if inflation remains a problem, we could see a rerun of that '70s show called stagflation.

Stagflation, for those readers who do not remember the Jimmy Carter administration, combines rising prices with slowing or non-existent economic growth. For businesses, it's the worst of both worlds, rising materials prices cut into their profit margins, while slower economic growth dampens consumer spending. The consumer suffers as well since even though the economy is slowing, inflationary pressures keep pushing the price of goods and services higher while the consumer may be dealing with minimal wage growth and/or corporate downsizing.

As the Gulf Coast region begins its massive rebuilding effort, stagflation is a serious concern as rising prices on many goods and record energy prices could seriously affect consumer spending. This in turn could lead to slower economic growth, as consumer spending comprises 70 percent of the nation's Gross Domestic Product.

So what does this mean for investors? How can you protect your portfolio against the negative impact of inflation and/or stagflation? Diversification is always a critical strategy, make sure you are not concentrated too heavily in one sector. Also, some inflation can actually be good for some parts of the markets and economy, assuming of course that the economy does not suffer a serious bout of stagflation. Investment areas and sectors that investors should look at in order to navigate the inflationary waters include short term, high-quality bonds along with floating-rate or adjustable rate bonds whose yields will reset relatively quickly to track the movement of interest rates. Another area to look at are TIPS, or Treasury Inflation Protection Securities, whose value is adjusted according to changes in the Consumer Price Index.

Finally, investors should continue to look at real assets for a portion of their portfolio. Whether energy-related, agriculture, metals or raw materials, hard assets have performed well in the past during times of rising inflation. As always, the key for investors is to make sure you are not too heavily concentrated in any one area.

Ideally, inflation remains in check while economic growth slows, but continues to show steady improvement. However, should the consumer keep their wallets on their hips, and the housing market continues to cool while prices rise, then we could see a return of the financial markets equivalent of the polyester leisure suit from the 1970s: Stagflation.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Consult a financial advisor prior to investing to help determine which investment(s) may be suitable for you.

Craig Rosenberg, owner of GT Asset Management in Traverse City, provided this article. GT Asset Management provides unbiased, financial solutions throughout northern Michigan. Rosenberg is a Registered Principal with and offers securities and fee-based advisory services through Linsco/Private Ledger, Member NASD/SIPC.

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