Serious Money: Is inflation about to make a comeback? If so, how should investors act to minimise potential damage to portfolios? Two decades of steadily falling inflation helped boost prices of both equities and bonds: is all of that about to end?

In the US and UK, for example, recent data have hinted that economy-wide prices might be creeping up a touch faster than previously thought. With oil prices at all-time highs and other commodity prices also riding a wave, the chances of inflation surprising on the upside are rising, particularly with many economies around the world showing signs of recovering from the soft patch experienced during the summer of last year.

Most asset prices, especially bonds and equities, hate inflation. Bonds always panic at the sign of higher prices because most of the instruments traded in those markets carry fixed nominal coupons - promises to pay a fixed sum of cash, at specified times, over the life of the bond. With the relatively small exception of indexed linked bonds - which, unusually, offer full protection from the ravages of inflation - higher prices gradually erode the real value of interest (coupon) payments and the ultimate value of the bond when it is redeemed at the end of its term.

The fall in global inflation which started in 1982 led to a secular bull market in bond prices. Bond yields (the reciprocal of prices) always incorporate a rough market guess as to the level of future inflation, as bond investors demand some protection from the obvious risks. As inflation, and inflation expectations fell, the inflation component of long-term interest rates (bond yields) also fell, leading to a trend rise in bond prices.

During the 1980s and 1990s, equities also did well. Some analysts argue that this was a direct consequence of the rise in bond prices and, hence, the fall in inflation.

Many simple (and not so simple) models of equity prices have bond yields lurking in the background as a key driving factor; markets were quick to spot the close relationship between equities and bonds - both were going up at pretty much the same time - and drew the obvious conclusion that the reason why equities were going up was almost entirely explained by the fall in bond yields.

This chain of reasoning, which is partly accurate but mostly bogus, reached its zenith during the late 1990s when low bond yields were erroneously used as a justification for lunatic levels of equity markets.

Lower inflation did help equities for many years, but not because nominal bond yields fell. Lower inflation acted to reduce implicit levels of risk premia built into stock prices: inflation itself is not such a destroyer of equity values as it is of bonds.

In a sense, equities can be contrasted to bonds and thought of as real assets - ones whose real worth isn't really affected by inflation. Dividend yields, unlike bond yields, can, in theory, be argued to be real yields: dividend growth will be higher during periods of high inflation and vice versa.

The problem that inflation causes for equities is the collateral damage accompanying central bank action to cure the problem of rising prices. Historically, recession has proved to be the main tool used to cure inflation problems. Economic downturns, particularly of the vicious kind, are anathema to equities since many companies experience falling profits and, moreover, some firms go bust, wiping out their investors.

Stock markets try to look through cycles but cannot ignore them for the simple reason that some firms go bankrupt.

Inflation fell for 20 years because it had to: it was doing so much damage to the world economy that the painful choices necessary for the cure were more palatable than the disease itself. Inflation is always like that: for a while, it doesn't seem so bad but its effects are insidious and the level of inflation itself can move with surprising swiftness.

So is it alarmist to speculate about a return of inflation? After all, one of the methods used to cure the problem of rising prices is still proving to be very effective: independent central banks are still there ready to pounce at the first sign of inflation pressures.

And it is true that while last week's producer price data in the US provided a massive upside surprise, broader measures of global inflation are not suggesting an imminent danger.

I am not in the camp that believes we are in for an inflation shock. But neither am I complacent: a number of indicators are, at the very least, flashing amber. I think we should be on watch for an inflation creep, rather than an inflation shock.

If that is right, it must mean that interest rates around the world, particularly in the US, are likely to end up at higher levels than currently discounted by the markets. Bonds are a sell on this view: only if you think an imminent collapse in global growth is about to throw creeping inflation into sharp reverse should people be thinking of buying bonds now.

Equities won't be too concerned about most of this, although they will cast a watchful eye on rising bond yields (falling bond prices). There is some elastic in the relationship but bond prices cannot fall continuously without stocks taking some notice.

Some inflation can actually be quite good for stocks, at least in the short run, since one of the reasons for higher prices is a return of corporate pricing power: profit margins can be expanded in ways that we haven't seen for years. But even equities can have too much of a good thing: beyond a certain level, inflation is unambiguously bad.

The problem for investors is that there are very few places to hide from higher inflation. Indexed linked bonds, as mentioned, are an obvious choice. Gold is often argued to be the classic inflation hedge, so anyone worried about the inflation outlook might think about a foray into this most peculiar of asset classes. Generally, commodities are also thought to be good hedged against inflation.

If there is an inflation problem out there I don't think it is going to affect dramatically financial markets for at least a quarter or two. But inflation has moved back onto the radar screen and needs to be watched carefully.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal