Apr. 5--Many believe the massive stimulus package that's beginning to flood the financial system may cure a lot of economic woes.

The problem is the outsized inflation that could well follow.

Mark R. Zellmer sees a high probability that inflation will be rekindled within the next few years.

Zellmer's response is to follow China.

Flush with dollars and worried that the Federal Reserve's move to expand the money supply will devalue its holdings, the Chinese government is seeking hedges.

"They're taking their U.S. dollars and putting them in hard assets real quick," said Zellmer, president and portfolio manager at Northern Oak Capital Management Inc. in Milwaukee.

Net foreign purchases of long-term U.S. securities went negative in February after years of climbing, he said.

The state-owned Aluminum Corp. of China teamed up with Alcoa Inc. in February to buy a 12% stake in Rio Tinto PLC, an Anglo-Australian mining company. Also in February, China National Petroleum locked in long-term commitments for oil supply when it signed separate agreements with Russia and Venezuela to provide $25 billion and $4 billion in loans, respectively.

Zellmer says he's helping clients do similar hedges:

"If you have any monetarist blood in your veins, if you believe inflation is driven by changes in the money supply, the absolute level of the creation of dollars has to catch your attention," he said.

Here is an investment he's using that he says will help create an inflation hedge:

Oil Services HOLDRs Trust (OIH, $82.66) holds shares of companies that provide drilling, well-site management and related products and services for the oil industry. It has traded as high as $227.48 and as low as $60.80 in the last 52 weeks.

Oil prices have been rising and OPEC is beginning to get better at controlling supply, Zellmer said. Meanwhile, many believe the world's oil supply has peaked and oil production will be more difficult.

The trust's biggest holding is Transocean Ltd. (RIG, $65.52), which has one-third of all the deepest water drilling rigs in the world, Zellmer said.

"If you think oil prices are going to be higher, the service companies will almost have to participate," he said.

The biggest risk Zellmer associates with the trust is the possibility the U.S. stimulus package might fail to spark demand, and deflation results, he said.

Oil Service HOLDRs' shares could go as high as $95 in the next 12 to 18 months, Zellmer said.

Zellmer also uses two exchange-traded funds to give investors exposure to precious metals:

SPDR Gold Trust (GLD, $87.59) invests in gold and has an objective of reflecting the performance of gold bullion, less the trust's expenses.

iShares Silver Trust (SLV, $12.60) invests in silver and aims to reflect the performance of silver, less the trust's expenses.

A third category Zellmer uses as an inflation hedge is agricultural commodities.

PowerShares DB Agriculture Fund (DBA, $25.00) tracks the Deutsche Bank Liquid Commodity Index-Optimum Yield Agriculture Excess Return Index, which is intended to reflect the agriculture sector.

Uncertain about where prices are going, some farmers are balking at planting all their acreage, Zellmer said.

"As the stimulus packages kick in, it wouldn't surprise me to see the prices of these commodities rise," he said.

Zellmer said he would put as much as 10% of the stock portion of a portfolio into investments related to oil, precious metals and agricultural commodities.

On the fixed-income side, Zellmer would use Treasury Inflation Protected Securities, or TIPS, a special type of U.S. Treasury note or bond that adjusts with inflation.

"They're not as cheap as they were in February, but I think to have some inflation protection on the fixed-income side makes all the sense in the world," Zellmer said.

-----

To see more of the Milwaukee Journal Sentinel, or to subscribe to the newspaper, go to http://www.jsonline.com.

Copyright (c) 2009, Milwaukee Journal Sentinel

Distributed by McClatchy-Tribune Information Services.

For reprints, email tmsreprints@permissionsgroup.com, call 800-374-7985 or 847-635-6550, send a fax to 847-635-6968, or write to The Permissions Group Inc., 1247 Milwaukee Ave., Suite 303, Glenview, IL 60025, USA.

NYSE:ACH, NYSE:AA, NYSE:RTP, AMEX:SLV, AMEX:DBA,

A service of YellowBrix, Inc.