For consumers, inflation is aggravating, but straightforward: We pay more for goods and services. As investors, inflation is more complicated. There are many definitions, sources and nuances. More important, inflation's surprising emergence across the globe has affected valuations and created significant challenges.

At the simplest level, price increases in food and energy have put pressure both on consumer spending and on corporate profit margins. In the United States, higher gas and grocery prices have imposed difficultlifestyle adjustments on consumers, with the falling dollar sharpening the pain. Still, the percentage of the average U.S. family's budget spent on energy and food is much lower than that spent by families in developing countries.

Compounding the challenge for consumers in many developing countries, governments are rethinking or cutting back subsidies for food and energy. Central banks have also been indirectly subsidizing their citizenry by managing a favorable currency-exchange rate to encourage the jobs and export revenues that result from a weaker currency.

This currency strategy is helping to transform globalization from a deflationary force to an inflationary force affecting the U.S. and other developed countries. And in emerging economies, this trend is exacerbated by growing wage inflation.
It's reasonable to expect some orchestrated moves toward currency appreciation across developing countries, particularly in Asia, where governments are trying to combat inflation while preserving economic growth. This is a mixed bag for global inflation. Less subsidized demand may improve global food and energy pricing, but stronger currencies will raise the cost of imports for developing markets.

Europe, like the U.S., has had to deal with widespread housing inflation and a subsequent reversal of house prices. Labor costs are uniquely important across Europeannations where collective-bargaining agreements prevail; a situation that the U.S. faced in the 1970s.

Of particular interest to investors, rates across many global fixed-income markets have been less than current and predicted inflation. This produces negative real rates, an unfavorable option for any but the shortest of time horizons. Still, the alternative of reaching for yield is fraught with potential risk.

Extending maturities to capture higher coupons leaves a portfolio vulnerable to a significant downside move in an inflationary environment. And moving from government debt to higher-yielding corporate bonds leaves one exposed to the vagaries of an uncertain credit environment. Meanwhile, yields on U.S. Treasury securities have been driven down by this year's flight to quality.

One attractive option is to selectively take on high quality credit risk with short-term investment grade bonds to mitigate the threat of unexpected inflation and the related downward pressure on longer-dated bonds. Resource and commodity allocations also can provide diversification benefits if the cyclical risk is acceptable. With corporate profit margins challenged and broad sectors of the economy floundering, equities may be a less attractive inflation hedge for some time. Stock selection can add value in this environment, however, as prudently capitalized firms with strong cash flows and defendable business franchises have served inflation-weary investors quite well over time. And if global inflation recedes with a slowdown in global demand, these same companies should not disappoint.

Tim Knepp, CFA, serves as chief investment officer of Genworth Financial Asset Management (an Encino, Calf.-based unit of Genworth Financial), as well as chairman of the firm's investment management executive committee. He can be reached at tim.knepp@genworth.com.