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Thematic Investing: Inevitable Inflation, but First, Deflation then Stagflation

We feel that one of the most fundamental decisions we face in building investment portfolios is correctly deciding whether we are facing an inflationary or deflationary environment in our future. Most investments behave quite differently depending on whether we are in a deflationary or inflationary environment. Get it wrong and your investment choices could rise up to bite you.

The Fed will fight deflation and knows how to do that (print money). They also know what to do when inflation becomes too high (raise interest rates). But there is a cost. In a normal world, the amount of monetary and fiscal stimulus we are witnessing would produce inflation in very short order. That is what has the "gold bugs" of the world excited. It is their moment. They keep repeating that inflation is always and everywhere a matter of too much money being printed. The answer to that is that the statement is mostly true, but not always and not everywhere (think Japan). The reality is somewhat more nuanced. When faced with the possibility of deflation, I imagine Fed Chairman Bernanke pouring bags of greenbacks out of a helicopter. When will they know when enough is enough? When the velocity of money stops falling (that is, when Americans quit saving and start spending on non-discretionary items). When we see two quarters in a row where the velocity of money is rising, then it is time to start investing in inflation hedges. The Fed has more room to print money than most of us realize. How much more? My bet is that we'll find out. Will they print too much at some point? Probably.

What we are looking at in our near future is not inflation. We are in a period where the Fed is in the process of reflating, or at least attempting to do so. They will eventually be successful (though at what cost to the value of the dollar one can only guess). One can have a theoretical argument about whether that is the right thing to do, or whether the Fed should just leave things alone, let the banks fail, etc. I find this a pointless discussion.

One way to cause pain to the most people is to allow deflation to develop over the next few quarters, thereby probably really hurting gold and other investments, before inflation and then stagflation become the end of our perilous journey (which of course would be good for gold, if you can hold on in the meantime). Former Fed Chairman Greenspan held down interest rates so long in order to spur the economy that now the best outcome of this economic cycle could potentially be stagflation -- stagnant or declining wages, an anemic economy, and a weaker dollar driving import prices higher.

Is it possible that we can find some “Goldilocks” end to this crisis? That the Fed can find the right mix, and Congress wakes up and puts some fiscal audits in control? All things are possible, but I wouldn't bet on it. While there are some who are very sure of our near future, I for one am not. There are just way too many variables. Let me give you one scenario that worries me. Congress shows no discipline and lets the budget run through a few more trillion in the next two years; the Fed is successful in reflating the economy; the bond markets get very nervous, and longer-term rates start to rise. What little recovery we are seeing (this is after the double-dip recession I think we may face) is threatened by higher rates in a period of high unemployment.

Does the Fed monetize debt (through quantitative easing = printing money) and bring on real inflation and further destruction of the dollar? Or allow interest rates to rise and once again push us into recession? (A triple dip?) There will be no good choice. The Fed is faced with a dual mandate, unlike other central banks. They are supposed to maintain price equilibrium and also set policy that will encourage full employment. At that point, they will have to choose one over the other. There are no good choices.

To learn more, read our Introduction to Thematic Investing. We strive to identify global themes that we believe are most likely to be important long-term drivers of the global business environment. Then we use intensive fundamental research and a wide array of quantitative tools to invest in companies that stand to benefit as these themes unfold. We believe this approach we help us to steer clear of trouble and stay focused on what's working, and making money.

Eric Linser, CFA | Green Valley Wealth Advisors | Oct. 1, 2009

Dollar Weakness Overdone - When Nouriel Roubini talks, people listen. And now Mr. Roubini has identified the U.S. dollar carry trade as the primary reason for “skyrocketing” stocks. Gloom-god Roubini says that flooding the world with U.S. dollars at non-existent interest rates has let speculators push assets far higher than their “fundamental value” justifies. That may be true.

Then again, when have assets ever been perfectly aligned with so-called “fundamentals?” Hasn’t there always been a willingness to risk, reward, speculate and, hopefully, come out ahead? (Note: Markets can be “overvalued” for years… even an entire decade. In 1996, Greenspan described the overzealous stock market in terms of irrational exuberance. It took 4 more years for that bubble to burst.) Roubini also says that the dollar cannot keep falling forever. This is a true statement, unless you believe the U.S. currency will collapse entirely. Yet once again, the U.S. dollar is not likely to strengthen by bounds and leaps overnight. High unemployment keeps many from passing on prices to end consumers. Non-existent inflation data encourage U.S. leaders to support a weak dollar policy. And the Fed isn’t expected to raise interest rates until the middle of 2010. Since it may take some time before the U.S. dollar gets legitimate suitors, the borrowing of U.S. dollars to invest in higher yielding and/or potentially higher appreciating assets is likely to continue for a while longer. The biggest problem is the attempt to diversify away from the dollar carry trade risk. It can’t really be done. Everything that people worldwide are borrowing to invest in — bonds, currencies, commodities, stocks — will be liquidated to pay the loans back if the dollar charts a path towards strength.The best defense, then? Keep an eye on PowerShares Dollar Bullish (UUP). If UUP climbs above 50-day and/or 200-day trendlines, you will assuredly need to raise some cash/take some profits.When PowerShares Dollar Bullish (UUP) rose 0.76% on Monday, 10/26/09 (through 3:00 PM EST), a significant amount for a currency in a single day, assets across the board got creamed. Which assets got smacked down the hardest? Assuming the U.S. currency reclaims a chunk of its former glory in the distant future, could this type of activity be a predictor of downside risk? (October 27, 2009)

Gary G.

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