Rotary encoders and shift registers?

Using Arduino LEDs and Multiplexing
6

Will a port expander work with incremental encoders?

Yes that is why I told you about it.

if I was using absolute encoders

Have you seen the price of these!!!!
http://uk.farnell.com/pepperl-fuchs/fvs58-011k2ragb-0013/encoder-absolute/dp/3778022