Your Pocketbook's Biggest Enemy

A healthy debate about inflation is under way. Understandably so, for whether you're at the grocery store, filling up your gas tank, or reading The Wall Street Journal, inflation is top of mind for consumers and investors alike. But, just how bad is inflation and are higher levels here to stay? There's no general consensus on that. The rhetoric is circling around factors such as the direction of the dollar and commodities, the effect of a U.S. slowdown on global growth, and how far the Fed will go with the tools at its disposal. Industry pundits and economists are far from reaching a common ground.

What's an investor to do amid all of this uncertainty? My colleague Christopher Davis recently wrote about how to protect your portfolio from inflation and suggested that commonly sought-after safe havens from inflation such as commodities and Treasury Inflation-Protected Securities may not be the best way to fight rising prices at this juncture. And Christine Benz devoted an entire issue of her monthly Morningstar Practical Finance newsletter to helping investors inflation-proof their nest eggs and also hosted a recent series of videos on inflation-fighting investments.

For this piece, we surveyed the thoughts of a few fund managers to see how severe (or not) they think the inflation threat really is.

Bob Rod: Inflation Is a Long-Term Problem
Bob Rodriguez, founder of  FPA Capital , thinks we're in for it: higher levels of inflation for the long haul, that is. In his latest commentary for shareholders, entitled "Crossing the Rubicon," he lambasts the Fed's response to the latest credit and liquidity crisis. Aside from pointing to the moral hazard risk that the Fed's rescue of  Bear Stearns  raises--that the government will be there to bail out irresponsible risk-takers--he also suggests that the Fed seems more concerned with saving troubled mortgage borrowers and corporations than it is with fighting excesses and inflation, and its moves are not without long-term consequences, inflation being a primary one.

Rodriguez' overall outlook is very cautious, and that viewpoint is reflected in the funds. He's gone so far as to call a buyer's strike that extends to all equities and high-yield bonds. He sees more storm clouds on the horizon and doesn't think stocks and high-yield bonds are cheap enough to compensate for the prospect of higher inflation, along with bigger risks facing the financial system.

PIMCO Calls for Mild Stagflation
PIMCO is well known for its ability to follow and accurately predict the direction of macroeconomic drivers, such as inflation. The firm nailed the depreciating dollar, housing slump, and economic slowdown in the U.S. Bill Gross and others at PIMCO now think that mild stagflation (inflation together with slowing growth) is in store for the next year. While they think the U.S. and other developed economies are well into a slowdown, they point to still-strong demand for commodities from emerging markets, which is keeping inflation pressures up for the time being. PIMCO has increased its inflation expectations slightly but still forecasts relatively mild rates (between 2% and 2.5%) for the next six to 12 months.

At PIMCO's last annual secular forum--where it develops its three- to five-year views--in May 2007, manager Bill Gross expressed concern about the longer-term inflation picture and pointed out that while some disinflationary pressures such as globalization and a growing labor pool may stem inflation for a while, he thinks those forces will lose some of their disinflationary power as global markets become more integrated. Given its outlook, PIMCO is gearing its portfolios toward high-quality bonds that are paying attractive yields, such as high-quality mortgage-backed bonds and municipal securities. They have also reduced several funds' sensitivity to rising interest rates.

Marsico Is Less Concerned
Tom Marsico and the other managers and analysts at Marsico Capital Management do an excellent job mixing their top-down macroeconomic views with stock-by-stock research to build concentrated growth portfolios. Having an opinion on inflation is a critical input into their analysis. In his year-end 2007 commentary, Marsico didn't express a high level of concern about inflation. He pointed to soaring commodity prices as a key reason why he couldn't afford to ignore it but said that he believes in the durability of structural disinflationary forces such as globalization and a growing labor pool (the very forces that Bill Gross and crew think will eventually become less disinflationary). On top of that, he opined that the softening economy would also help keep inflation under wraps. 

He must not be too worried about inflation or its effect on the consumer because  McDonald's Corporation  (MCD) is one of his largest holdings in  Marsico Focus (MFOCX) and  Marsico Growth (MGRIX).  He thinks that McDonald's is improving the quality of its menu and bringing in a larger variety of items that should keep people coming to the fast food chain for more than just a meal.

And So Is Bill Miller
Bill Miller, longtime manager of  Legg Mason Value (LMVTX), thinks we're well into a commodity bubble, one that may have longer to run before it ends. He thinks that the Fed could help the situation by putting an end to its interest-rate cuts. If the Fed does that, he says, the dollar would likely stabilize, commodity prices would stall, and inflation pressures would relax. The end of the commodity price boom would undoubtedly help Miller. Legg Mason Value, which has excellent long-term returns, has been held back in recent years in part because it has avoided high-flying energy stocks. Miller is optimistic about equities more generally and thinks that the stocks in the portfolio have declined more than their business values. So, he's sticking with it.

There you have it: Two investors who run bond funds are worried about higher inflation and two equity investors aren't as concerned. The differences in opinion may be somewhat reflective of the different lenses with which these managers view the world. Any threat of inflation is worrisome for bond managers because it drives down the prices of the fixed-rate bonds they own. On the other hand, stock investors might think--well, my companies can raise prices, too, and if their revenues are rising at a faster clip than their variable costs, then that's a good thing.