NEW YORK (CNN/Money) -
This week's economic data showed that the continuing recovery is creating the kind of pressures that precede a rise in inflation. And Wednesday's report of a March uptick in the consumer price index confirmed the trend.
Now investors and analysts are watching to see if the Federal Reserve reacts by raising short-term interest rates.
In fact, there are several reasons to expect that the Fed will hike rates this year. In the scenario that many analysts think most likely, the Fed will nudge up short-term interest rates by one-quarter percentage point sometime between June and August. A second quarter-point increase would occur in November. At year-end, therefore, the Federal funds rates would be running about 1.5 percent, with at least one more increase likely in 2005.
There are three reasons to expect such a pattern.
First, the economy has been in recovery for two and a half years, growing at an average annual rate of more than 3 percent. Moreover, growth is finally fast enough to spark new hiring that will begin putting upward pressure on wages.
The second inflationary factor is the rise in oil prices. The U.S. recovery and soaring demand in developing countries such as China will tend to push up oil prices, as well as the costs of other raw materials, such as aluminum and copper.
Finally, a growing economy not only boosts wages and the prices of raw materials, it also slowly uses up all the slack in manufacturing and service businesses.
The eventual result: Higher inflation. Since the Fed always tries to lean against that, it's likely that the central bank will raise rates over the next year to prevent the economy from heating up too fast.
But investors are making a big mistake if they think that will automatically be bad for stocks.
A little bit doesn't hurt
Higher interest rates usually kill the bond market right away. For the stock market, however, moderate increases in interest rates during the early stages of a rebound are usually viewed as a sign that the recovery is healthy and getting stronger.
Expectations for rising corporate profits add more to share prices than higher rates subtract. It's only when the economic recovery is fully mature and higher rates are seen as the result of inflation caused by bottlenecks that rate increases are automatically negative for stocks.
You don't have to take my word for it. The Leuthold Group, an institutional investment advisory firm in Minneapolis, recently took a look at the relationship between interest rates and the stock and bond markets over the past 50 years.
Leuthold's finding: Since 1955, there have been 11 distinct periods when Treasury bill yields rose and stock prices also moved higher.
During those periods, short-term interest rates typically rose more than two percentage points. In many of those periods, long-term bond yields typically rose by 1.3 to 1.5 percentage points.
Given current market levels, such a move could knock down Treasury bond prices by about 15 percent, leading to net losses of 10 percent or so even after interest is taken into account.
The S&P 500, by contrast, gained an average of about 37 percent during those periods -- and as much as 60 percent in one case. Moreover, these periods often lasted longer than one year and once reached nearly three years.
Where the risk is
Given the capacity in the U.S. economy that is still underutilized and strong productivity trends, I wouldn't be surprised to see the current bull market in stocks continue for at least another two years, even with the expected rise in interest rates.
Bonds, however, don't look especially promising for capital gains -- including junk bonds which also seem near the end of their cycle. There's a case, of course, for keeping some bonds to diversify your investments, but I'd try to substitute other income investments wherever possible.
Unfortunately, real estate investment trusts are looking riskier, as well. Once short-term interest rates start rising, mortgage rates follow. And today's real estate price are so high that there's a risk higher mortgage rates will deflate property values.
It's absolutely essential at this point in the business cycle to add inflation hedges to your holdings to preserve your purchasing power in the face of rising consumer prices. Yesterday's column featured three oil stocks and three other picks worth considering (see them here).
Beyond that, the current outlook seems bright for the type of blue-chip companies with moderately above-average growth prospects that I recommend as the core of any long-term portfolio (see the Sivy 70 for examples). Big stocks are undervalued relative to small caps for the first time in 20 years. And companies with steadily growing earnings have an easier time staying ahead of inflation.
Keep an eye on inflation and interest-rate increases by all means. But don't assume the boom is over. Steady additions of undervalued stocks with slightly above-average earnings growth will still keep your portfolio on track to meet long-term financial goals.
Michael Sivy is an editor-at-large for MONEY magazine. Sign up for free e-mail delivery every Monday and Thursday of Sivy on Stocks.
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