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Friday, November 5, 2010

QE2 State of Mind....

When you are investing in the markets you need to arm yourself with the best information possible otherwise your chances of success are very limited. To get the best information you need to read many sources and get different points of view to formulate your opinion; this means reading viewpoints of those who agree with you and those that do not. I have been reading, watching and thinking about all things market related and interrelated for years, which has driven me to the conclusion that our future is one of inflation and not deflation.  Since I believe that there will be significant inflation I have been recommending hard assets and other investments that rise in price as both the inflation rate climbs and the currency gets debauched.

In keeping with my practice of reading opposing viewpoints I came across an article written by Martin Hutchinson on the Daily Markets website in which he makes an argument that it is time to shift from commodities to US stocks. While I have read many articles by Mr. Hutchinson and agree with most of his conclusions, but on this I disagree. His thesis is that the Republican victory taking the house and “B52 Ben’s” $600 Billion air drop have fundamentally altered the investment landscape for the next two years.  We agree that the two aforementioned items will alter the landscape; however, where we disagree is on their impact.

Mr. Hutchinson places more faith in to the notion that the Republicans will be able to meaningfully cut the deficit. I do not believe that that will be the case as they still have to deal with public perception and cutting too deeply will reflect poorly on the Republicans and they are still worried about 2012 and dislodging Mr. Obama.  I do think that they will be able to trim items and make reductions but we are looking at small figures in the grand scheme of things when we are talking $100 Billion as reported in the media. The figure I mentioned would be an enormous sum of money for an individual but it would only reduce this years’ deficit from $1.2 Trillion to $1.1 which overall is not meaningful to create any boom or confidence….but it don’t hurt either. Moreover, both parties have long been doing this political “Dancing with the Stars” routine, where each side gets what they want from their agenda while  lambasting the other side and I don’t see this changing unless we can decapitate the 2 headed 1 party system.

Hutchinson’s second point was that the $600 Billion would be used to fuel the least productive option in the US Economy which is buying Government Debt, which I agree with. He goes on that the theory is the money will drive down interest rates and force banks to finance small business growth that would in turn create jobs. I believe that Hutchinson is misreading the FED’s intent because he makes the assumption that the FED is concerned about small business, which it is not. Instead the FED is concerned about the banks and the government and maybe big business to some degree. The FED will use the cash to buy longer dated treasuries in a two pronged effort to 1) lower long term interest rates to attempt to shore up the housing sector which has a direct impact on member banks and 2) allow the rollover government debt to be financed for longer duration at lower rates. An enormous amount of Government debt is coming due over the next two years and will have to be refinanced and also compete with current debt financing needs.  Hutchinson is correct though in pointing out that the QE2 will cause inflation outside the US just as QE1 did, but he fails to make the connection that the internal net result will be a decline in the dollar. The decline in the dollar will cause price rises and inflation throughout the economy as the dollar continues to become worth less and less. These are the reasons that people, big money included are buying hard assets. I do agree with Hutchinson that there are good buys in US stocks but it will be a stockpicker’s market when it comes to that. As for the emerging markets the FED’s policies will continue to drive dollars there and levitate them which in turn will lead to further currency interventions on all sides.

In my opinion the FED’s QE policies are specifically designed to ramp up inflation since debt in an inflationary environment becomes more manageable because you have more worthless dollars with which to pay. Of course the average individual does not benefit from the inflation since they are usually the last to get their hands on the cash as it continues to depreciate in value especially since we do not currently have wage inflation. To demonstrate why the FED is pursing these inflationary policies on behalf of the debtors is simple. Look at a begin inflation environment and you can understand the situation. Dear reader let’s take a hypothetical person “Harry Homeowner” and go back in time a few years ago. Harry and his family purchase a home for $100K and put down 20% leaving them with a mortgage of $80K, and Harry earns $60K a year. The inflation rate is 2% and ten years have elapsed. Over the course of 10 years Harry’s salary has only adjusted by the two percent inflation per year and no merit raises, so it increased from $60K to a little over $89K on inflation alone. Harry’s mortgage is a 30 year fixed at 6% so the payment is level at 596.97 a month. On a pretax basis the annual mortgage payments consume 12% of his annual salary but after 10 years of 2% wage inflation the same payment is only 8% of his salary. In this scenario Harry is not really richer but his debt burden is reduced since he is paying the loan back with debased dollars.  The same is true of Uncle Sam’s $13+ Trillion in debt, if the FED can debase the currency which will generate inflation at a sufficient level over time then the debt burden will be reduced. The problem I have is I don’t have the confidence that the FED can control inflation once the genie is out of the bottle, and I cannot envision congress showing any true fiscal restraint. I also am concerned that the capacitors of inflation that we have pushed out on the rest of the globe could be unleashed at a inopportune time for the US causing severe dislocations and excessive inflation.

I will have to give this whole QE2 scenario more thought but for the foreseeable future all signs seem to point to higher inflation on top of a ton of inflation which was baked in to the cake with QE1. To me this whole QE2 has lots of unintended consequences and will lead to repercussions from around the world that will affect the US in ways we cannot yet see. In the mean time I do not see any evidence to dissuade me from maintaining my positions in hard assets and other inflation sensitive assets.

Have a great weekend!!


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