How overseas inflation could hurt investors

Inflation isn't hitting your wallet hard, but it is lurking in your stock portfolio.

Inflation isn't hitting your wallet hard, but it is lurking in your stock portfolio.

Core inflation in the U.S. is 0.8 percent, well below the 4 percent rate that starts to worry economists. Though food costs are rising, the overall inflation rate is expected to hold steady due to stagnant real estate prices.

So what's the worry?

Fast-growing economies in places like China, Brazil and India are growing too fast -- at more than 5 percent a year. That is resulting in higher prices for raw materials and consumer goods, leading to interest rate hikes that are already sending stock markets plunging in those countries. These are ominous developments for U.S. investors who have fattened their portfolios by investing in emerging markets and by buying shares of domestic companies that do business there.

Globalization long ago spread the revenue and profits of the companies in the Standard & Poor's 500 stock index beyond the shores of the United States. Fifteen percent of the profits of companies in the index are from emerging markets.

Growth overseas has helped lift the S&P 500 up 23 percent over the past 12 months, pushing company revenues higher despite the slow economic recovery in the U.S. Companies in businesses from trucks to toothpaste continue to expand into the developing world. Caterpillar Inc. made 12 percent of its revenue from Latin America in 2009, a 4 percentage point jump since 2004. Procter & Gamble, the company behind household staples like Crest toothpaste and Pampers diapers, made 32 percent of its revenues from emerging markets the same year, an 11 percentage point jump since 2004. Ford Motors Co. sold 9.2 percent of all of its vehicles in South America in 2009, a five percentage point jump from five years earlier.

"Investors are not aware of how important emerging markets are for the valuation and earnings for so many U.S. companies," says Nicholas Colas, chief market strategist at ConvergEx Group. Caterpillar, for instance, jumped 84 percent over the past 12 months largely due to sales of construction equipment in China and Brazil.

Investors have assumed that profits in emerging markets will continue to grow as millions join the global middle class. But if central banks take drastic steps to halt growth and tame inflation, then the stocks of U.S. companies that do big business there will fall.

"That is what I'm most fearful of right now," says Nick Kalivas, vice president of research at MF Global, a financial services firm in New York.

China said Tuesday that its central bank was raising interest rates for the second time in just over a month. Brazil said Wednesday that it would slash $30 billion in spending to cut inflation that jumped to 5.9 percent in 2010. India's central bank raised interest rates in late January for the seventh time in little over a year after its inflation rate hit 8.4 percent. By raising interest rates, central banks hope to slow borrowing and other economic activity that can push prices higher.

Inflation makes companies that sell consumer goods compete with the basic costs of living. Every increase in the already high cost of food cuts directly into the money that consumers in emerging markets have to spend on small luxuries or electronics. Hershey Co., for instance, could find that the 12 percent jump in the cost of cocoa this year will cut into its expanding revenues in China if consumers decide that they can't afford more expensive candy bars.

There isn't the same worry at home. "The U.S. economy has an enormous capacity to absorb increases in demand without causing dramatic widespread inflation," says Burt White, chief investment officer at LPL Financial.

Investors in overseas markets have already taken a hit. India's stock market has fallen 15 percent this year. Brazil is down 6.5 percent, and China is off 5 percent.

There are already signs that overseas inflation is creeping into the U.S. stock market. Materials companies in the S&P index — which sell basic goods like steel — have lagged behind the market since the start of the new year, rising only 3 percent compared with the 5.7 percent rise in the broad index. Consumer staples, another group of companies that are affected by inflation, are up less than 1 percent for the year.

Energy companies, meanwhile, are the most likely to benefit from global inflation because people will buy gas even if it costs more. They are up 8.8 percent so far this year, the most of any company group in the S&P index.

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