Inflation boost for food retail stocks

Stubbornly high inflation in Europe is set to create a clear divergence in stock market investors' preferences this year, with food retail, commodity companies and utility shares likely to be in hot demand.

Ballooning food and fuel costs have asserted price pressure around the globe, limiting the ability of many central banks to cut interest rates even as a meltdown in the US subprime mortgage market leads to slower growth.

Within stocks, retailers like Tesco and Metro, water group Veolia and utility EDF can provide a hedge against rising prices, analysts said.

"What we've found historically in inflationary periods and especially in stagflationary periods, is you want to be in sectors that are the source of inflation, or which have inflationary pricing or decent pricing power," said Ronan Carr, European equity strategist at Morgan Stanley.

In the eurozone, inflation moderated in April to 3.3 per cent from a record high of 3.6 per cent the previous month but well above the European Central Bank's medium-term target of just below two per cent. The Bank of England expects inflation in the UK to shoot up this year and stay above the central bank's target in two years if interest rates fall.

"Consumers are cash strapped. They are seeing that a lion's share of their disposable income is being eaten up by rising fuel and food costs," said Stephen Pope, head of equity research at Cantor Fitzgerald.

"The money they have over for joyful disposable, pleasurable things is somewhat limited. So anything that interfaces with the general consumer is going to have difficulties."

Although higher inflation can hurt returns for equities, it is much worse for bonds. Morgan Stanley said UK data showed the probability of bond investors making a positive real return (after inflation) in any 12-month period since 1925 was 47 per cent and the average real return was -1.6 per cent.

On the other hand, equity investors had a 66 per cent probability of making a positive real return in any 12-month period and the average return was 6.3 per cent.