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The euro and benchmark German bond yields slid to three-week lows on Friday as a surprise fall in Spanish inflation bolstered investors’ bets the European Central Bank will ease policy next week.Getty Images/iStockphoto

There's nothing like an unexpected uptick in inflation to remind us that our environment of very low inflation could one day end – with the potential to upset a lot of investments.

On Tuesday, the U.S. Department of Labor reported that the consumer price index in May rose 0.4 per cent over the previous month and 2.1 per cent year-over-year, or the highest rate of inflation in nearly two years. Even after stripping out volatile food and energy items, CPI rose 2 per cent over last year, up from 1.8 per cent last month.

That's not high, but it's moving up toward the Federal Reserve's comfort zone. For now, economists sound confident that the Fed will leave its key interest rate unchanged until next year, but Tuesday's report has clearly rattled their forecasts a little.

"It is clear that inflation is approaching its target with, perhaps, slightly more gusto than originally anticipated," said Francis Fong, an economist at Toronto Dominion Bank, in a note. "If growth accelerates significantly through the remainder of this year and price pressures continue to mount, then the calculus could move in favor of an earlier start to the hiking cycle."

David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates, believes the Fed is in no hurry to shift gears on monetary policy, but that simply makes rising inflation more a likely prospect.

"The bottom that employment lags the cycle, unemployment rates lag employment, and wages lag everything," he said in a note. "So what we have is a Fed that is committed to targeting lagging indicators – this can only end up building inflationary pressures down the pike."

Investors have been living with low inflation – and the threat of deflation – for so long that the prospect of higher inflation sounds intriguing, if a little unsettling. Bonds are certainly at risk if the consensus call among economists for rising yields plays out.

But what about stocks? Julian Emanuel, a strategist at UBS who believes that higher inflation is coming, noted that environments of rising inflation, rising interest rates and higher volatility have been positive for stocks since 1998, the year that marked the end of inflation's secular decline. On average, the S&P 500 has gained 16.7 per cent annually under these conditions.

But be prepared for some bumps: "A short term setback in equities is likely in the event of interest rate uncertainty leading to higher volatility," Mr. Emanuel said. "However, we would view any such setback ultimately as a buying opportunity, particularly were the VIX [volatility index] to spike above 20, as occurred earlier this year."

He created a list of U.S. stocks that should perform well when inflation is rising, based on their historical correlation with inflation. These stocks include Buffalo Wild Wings, Home Depot Inc., Procter & Gamble, McDonald's Corp., Kimberly-Clark, Starbucks Corp., Wynn Resorts Ltd., Target Corp. and Colgate-Palmolive.

Savita Subramanian, equity and quant strategist at Bank of America, is also weighing the prospect of rising inflation on her sector picks: "We are underweight Consumer Discretionary, particularly U.S.-focused retailers, as near-record margins may be most vulnerable to rising rates and wage inflation," she said in a note.