Infrastructure: The new gold

By Jim Jubak

Just when you needed something else to worry about: Inflation isn't dead.

But, hey, I've got good news, too. I've found a way that you can make more money from inflation and lower the risk from inflation in your portfolio at the same time.

Diversify into infrastructure stocks. I'd go so far as to call them "the new gold."

According to the Producer Price Index numbers released March 15, inflation isn't dead. The headline index of inflation at the wholesale level climbed at an annualized rate of 2.5% in February. That's not good news, since future inflation at the consumer level often follows the wholesale trend with a lag of six months or so. An annual 2.5% rate is certainly high enough to make the Federal Reserve nervous about cutting interest rates, as Wall Street hopes it will in the months ahead.

In a normal financial market, I'd advise adding to positions in gold and other commodity stocks as a hedge against inflation. The prices of the underlying commodities typically go up when inflation climbs, and the stocks of commodity producers climb even faster, since their earnings rise faster than the prices of the commodities themselves. That's because the costs at these companies are largely fixed, so increases in commodity prices drop straight to the company's bottom line.

Not business as usual

But as I wrote in my March 16 column, "Investors, there's no place left to hide," this isn't a normal financial market. Because the 416-point sell-off of Feb. 27 was largely a result of traders unwinding speculative positions purchased with borrowed money, the prices of gold and other commodities didn't zig when the stock market zagged, as they usually do. Instead, since traders were also selling speculative positions in gold and other commodities, shares in these sectors went down along with everything else.

I'm a long way from abandoning gold and other commodities as hedges against inflation. The sell-off in this sector seems to be over, and the price of at least one commodity, copper, is on the rise. So I'm going to stick with my commodity stock plays: GoldCorp (GG, news, msgs), Kinross Gold (KGC, news, msgs), Anglo American (AAUK, news, msgs) and BHP Billiton (BHP, news, msgs) -- especially because these stocks are also good hedges against the long-term downward trend in the U.S. dollar.

But as I said in my March 16 column, it's time to re-examine the assumptions behind portfolio diversification. The unwinding of global leverage and the re-pricing of risk in the asset markets that started on Feb. 27 is a long way from over. Investors who want to take some of the risk out of their portfolios by diversifying into asset classes that will go up when everything else goes down need some new tools.

For the next decade, at least, I think investors should think of infrastructure stocks when it comes to hedging against inflation.

I started to think about the infrastructure sector -- the stocks of companies that make the raw materials for building roads, ports, rail lines, airports, etc., that do the actual design and construction work on those projects and that raise the money for these projects -- when I read reports on the Indian and Brazilian economies, both issued almost simultaneously, calling for massive new investments in infrastructure to increase economic growth and to fight domestic inflation.

Increasing growth by building roads and other infrastructure projects has been a standard tool of governments at least since the days of the Qin emperor who started the Great Wall of China in the third century B.C. Spending on infrastructure creates jobs that lead to more economic demand that creates yet more jobs. So that part of the dual announcements wasn't especially surprising.

A new idea

But the notion that building infrastructure was a way to fight inflation? Now that was an interesting wrinkle to someone looking for new tools to use in diversifying a portfolio.

The report on the Brazilian economy from the World Bank came out in early March. If Brazil wants to grow faster without a huge increase in inflation, the country must increase investment in infrastructure to 3.2% of Brazil's gross domestic product ($492 billion in 2006) from the current 1% rate. The government of President Luiz Inácio Lula da Silva has promised to deliver 5% economic growth in the president's second term, which began in October, up from 2.9% growth in 2006. The government's plan calls for an additional 0.5 percentage point of GDP, for a total of 1.5%, to be spent on infrastructure projects. That's clearly inadequate if you follow the logic of the World Bank report, which says that adding 4 percentage points of annual GDP growth would require infrastructure spending of 5% to 9% of GDP. You do the math.

Investors and government planners don't need to imagine what will happen in Brazil if the country doesn't make the investment in infrastructure. They just need to look to India, where decades of underinvestment in roads, ports, airports and rail lines are a central cause of the inflation now at a two-year high of 6.7% and running out of control in the country.

Take a look at the agricultural sector of India's economy to see the connection between infrastructure and inflation. While inflation in the economy as a whole is running at more than 6% annually, inflation in food prices is at 11%. Some of this inflation can be blamed on short supplies of foodstuffs such as wheat and pulse, the legume that plays a central role in the Indian diet. A terrible wheat harvest in Australia caused by drought has driven up wheat prices around the globe.

Rotting in the fields

But much of the country's soaring rate of inflation in food prices is self-inflicted. Somewhere between 30% and 40% of the country's crops rot in the fields or spoil in transit because of the country's creaky infrastructure. There simply isn't any way to get the food to market in time. What does make it through the supply chain is subject to huge markups at each stage of the process, because getting food from warehouse to distribution center to retail store to consumer is so time consuming and cumbersome. Consumers pay twice as much for wheat, for example, than do wholesale buyers. That adds another layer of inflation to food prices at a time when food inflation doesn't need any help in running wild: Wholesale wheat prices jumped 54% between April and November 2006.

Agriculture isn't the only sector of the economy paying the price. On overcrowded highways, speeds average less than 20 mph. Major cities in some Indian states cut power to factories one day a week. Ships have to be unloaded manually and cargo manually loaded onto trucks. Getting cars the 900 miles from the factory to the port at Mumbai takes one automaker 10 days.

India spends just 4% of its gross domestic product on infrastructure in comparison to the 9% spent in China. That disparity has existed for more than a decade. As a result, while China has 25,000 miles of expressways, India has just 3,700 miles.

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