The slow but steady return of inflation and how to profit from it

Concerns about inflation have dropped off the radar in the last few months.

On the one hand, the data hasn't sprung any more obvious surprises. And on the other, markets have had other things to worry about, like war both trade wars and actual wars.

But what with oil and other commodity prices surging this week, suddenly inflation is back in investors' minds.

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And for good reason.

Slowly but surely, here comes inflation

As Tom Traill points out in Economic Perspectives, core inflation in the US came in at 2.1% in March. That doesn't sound too bad a bit above the Federal Reserve's desired 2% target, but hardly a disaster.

But average weekly earnings growth which is less prone to the statistical quirks that sometimes hit the hourly earnings figure came in at 3.3%. And according to the Atlanta Fed, people who move jobs now earn themselves a rise of 4.4% on average.

Higher wages are not a bad thing, especially not now, when the share of wealth going to capital rather than labour has rarely been as out of line. However, rising wages also suggest that inflationary pressures are only going to go up. If people have more money in their pockets, they tend to spend more; more spending means more demand, which means higher prices.

Meanwhile, US manufacturing activity continues to strengthen another good lead indicator of rising inflation. In short, it's only a matter of time before inflation springs another surprise on markets.

And investors having been rattled briefly by talk of trade war and sabre rattling elsewhere look as if they're starting to get nervous about that again.

The yield on the ten-year US Treasury (what it costs the American government to borrow money for a decade) rose back above 2.9% yesterday for the first time in a month, according to the Financial Times.

The rise was driven by rising commodity prices (more on that in a moment) and by better-than-expected economic data (initial claims for US unemployment benefits fell to 232,000 last week, a bit lower than expected, and manufacturing activity in Philadelphia also beat hopes).

Slowly but surely, we're moving into a more inflationary environment. It's taking the market a while to wake up to that, but things are steadily shifting. So how can you take advantage?

Canada cheap compared to both the US and its own history

The most obvious way to play a rising inflation environment is via the commodity sector. Following on from what we were talking about yesterday the rising oil price we're already seeing a pick-up in activity across that sector.

As David Rosenberg of Gluskin Sheff notes, oil stocks are picking up, having been beaten down for a while. "Energy almost always emerges as a classic late-cycle outperformer." And Rosenberg is interested in one economy in particular Canada's.

Rosenberg reckons that Canadian stocks look pretty cheap. Relative to US stocks they are trading at a "record differential", he notes. OK, you might think, but that's because US stocks are so expensive that doesn't mean Canadian stocks are automatically cheap. And you'd be right.

But as Rosenberg points out, even compared to its own history, Canada is not expensive. For perspective, the S&P 500, he says, has only been as expensive as it is now for 3% of its history. By comparison, the Canadian index has been valued at current levels or higher around 60% of the time. "In other words, Canadian equities trade today in the lower half of the historical valuation range."

And he reckons that energy stocks in Canada in particular "may have the most alluring risk-reward attributes on the continent at the current time, if not the planet".

The biggest problem with Canada

The biggest fly in the Canadian ointment, from where I'm standing, is the housing sector. Canada has like Australia enjoyed one of those never-ending house price

booms. Inhabitants of the UK may be fed up with ever-rising house prices, but Canada and Australia didn't even really see much of a blip during the global price crash in 2008 and 2009.

That's ending now though (which is fascinating in itself we talked about the global prime house price synchronisation phenomenon here). Prices in Toronto, for example, are now down about 7% from their July peak.

As a result, banks, property companies and consumer stocks are all relatively cheaply-valued in Canada (energy is the other sector in the "cheap" bucket). And you can understand why. If house prices fall, then builders will get hit; banks will see their bad debts rise; and people won't have as much money in their pockets, so shops will suffer too. We all know this drill from 2008.

Moreover, Canadian consumers are massively indebted. And more than a trillion dollars of mortgage debt needs to be refinanced next year (roughly half of all the mortgage debt outstanding). That's as good a reason as any to expect Canada's central bank the Bank of Canada, naturally to be very careful about raising interest rates.

That said, Rosenberg reckons most of this is "in the price" particularly if central bankers in Canada maintain their bias towards the bearish side. So if you weren't so keen on the idea of investing in Russia, as I mentioned as an option for betting on oil yesterday, then maybe you could swoop on Canada instead.