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Inflation expectations are on the rise in Canada. It seems its time for investors to ditch the bond market and dive into an equity market primed for plum pickings.

“As the result of the inflation expectation rising, we will at some point in time see bond yields rise,” says Paul Taylor, chief investment officer, BMO Harris Private Banking. “For those who are investing in the bond market, that will mean capital losses on their bond portfolio. It probably means your total return on a bond portfolio could be flat and even negative going forward.”

Advisors and investors need not panic. Taylor says stocks and cash can counterbalance this risk.

“I’d rather be in a juicier dividend paying common equity where you have at least better coupon income,” he said.

Apart from dividend stocks, elevated energy prices offer another area with some good potential. “Our general stance has been to go to equities over bonds and cash, and go to cyclical stocks over non-cyclical stocks at this point in time in the capital market cycle because we still believe that we’re in relatively early stages of multi-year global economic recovery.”

Advisors would do well to keep an eye on inflation and hedge against it. “Beware of those assets that do not provide attractive inflation protection; there is a large potential for a non-happy ending,” says Taylor. “Precious metals, base metals and energy are certainly areas that provide better downside protection in an inflationary environment.”

So how is inflation playing itself out in Canada? There is much noise about inflation—and the impending interest rate hike—and investors are struggling to make sense of it all.

Inflation is bit of a concern, admits Taylor but suggests investors take a step back and look at the big picture for some sense of perspective.

“We know the top-line inflation number is being dramatically affected by energy prices, gas prices specifically,” he says. “We know that consumers are paying more at the pump and that’s causing the top-line inflation number to move to the upside; in addition, food price inflation is a reality.”

Even after discounting the volatility of food and energy, inflation in Canada is still running at 1.7%, well within the Bank of Canada’s (BOC) 1% to 2% range. Taylor, however, fears “inevitably higher energy and food prices will end up being passed through [to] the core inflation.”

“There is no doubt we’re developing some upward pricing tendencies; and we will have to watch carefully to see how this plays out.”

That would inevitably involve keeping tabs on economic developments south of the border where the tenuous recovery is still taking hold. Taylor is betting against the U.S. Federal Reserve removing the punch bowl from the party in the immediate future.

“They are going to wait until we have had three or four quarters of decent employment growth, he says. “They are going to look to see that inflation has truly started to become a clear issue before they start moving higher.

Bottom line, he doesn’t see U.S. interest rates rising this year, but the ever-cautious Bank of Canada is a different story. “Maybe this fall they will get ahead of the Fed,” with a rate hike possibly coming in September or October.

A recent announcement from the C.D. Howe Institute seems to go a step further. It suggests the Bank of Canada raise the overnight rate after putting it off for five consecutive announcements since September 2010, the last time it raised the rate to 1%.

The Institute’s Monetary Policy Council recommended that the Bank of Canada raise its target for the overnight interest rate to 1.25% at its next announcement on May 31, 2011.

“The Council further recommended raising the target rate to 1.50% at the following announcement on July 19, 2011, followed by increases that would take it to 1.75% in December 2011 and 2.25% in May 2012,” the institute said in a recent release.

Originally published on Advisor.ca

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