by Dave Kansas
The Federal Reserve has unleashed its latest effort to goose the economy, dubbed Quantitative Easing 2, and global stock markets have cheered. When you announce plans to print $600 billion and "throw it at the problem" people can show a tendency toward giddiness.
Now, less than two weeks after the Fed announced QE2, some of the giddiness is giving way to consternation and unease. In the run-up to the G-20 meeting in Seoul this past week, Germans, Chinese, Brazilians and Russians (anyone left?) all made strong complaints about QE2, arguing that the printing of still more dollars could destabilize the global economy. Fed Chairman Ben Bernanke countered that the Fed's job is to focus on the U.S. economy, not everyone else's. Translation: "We'll do what it takes, and the rest of you can pound sand."
The unease emanating from QE2 is the specter of inflation. And while inflation remains a distant concern, it makes sense to start thinking about firming up the inflation defenses in your portfolio.
One reason to tread carefully on this issue is that a number of smart economists argue that inflation isn't a real worry, and won't be any time soon. The main evidence: Japan.
Since the early 1990s, the Japanese have spent huge sums and embarked on several clever QE-style strategies. Today, the country faces deflation concerns, not inflation issues. Similarly, easy money during the past two-plus years hasn't led to inflation problems in the U.S., despite frequent warnings.
And yet, inflation signals continue to bubble to the surface. Gold, considered a store of value in inflationary times, soared to a fresh string of records after QE2 was announced and now trades above $1,400 an ounce. Prices of other commodities, including industrial metals, agricultural products and oil, also have jumped to new highs. The faltering dollar is both helping drive commodity prices higher and raising the possibility of imported inflation.
"At some unknown point, easy money turns into excess leverage, reduced deflation risk becomes inflation fear, fiscal stimulus becomes sovereign credit risk," says the J.P. Morgan Chase asset-allocation group in a recent note. "We can't tell where this turn comes, but history warns us it tends to happen suddenly and violently. As investors, you can't always focus on tail risk, but it makes sense to tilt portfolios toward them."
Even the midterm elections could contribute to inflation expectations. "Higher inflation would help push the unemployment rate down and, most importantly, inflation would help reduce our debt burdens in nominal terms as we pay off our fixed obligations with cheaper dollars," says Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "The jury is out on whether or not [QE2] will ultimately spark inflation. The key thing to remember is that Washington policymakers, divided or not, can all agree on inflation."
So, what to do? Given that inflation isn't at anyone's doorstep, despite howling from some quarters, you should act with prudence and not haste. Most professionals recommend edging your portfolio toward beneficiaries of inflation, which usually include commodities, real estate and stocks. Some also recommend starting or adding to a position in Treasury inflation-protected securities, or TIPS.
TIPS are the most direct way to guard against inflation, and earlier this month an auction of 10-year TIPS had enormous demand, resulting in a record-low yield. That means investors are exceedingly confident that the Fed will succeed in its bid to spark inflation, but it also means TIPS aren't exactly cheap these days.
Advisers recommend that investors hold 5% to 10% of their investment portfolio in commodities, partly as an inflation hedge. This is probably good advice. Food prices are expected to keep rising in 2011, along with oil and metals.
Real estate and equities are tougher calls. The U.S. real-estate market remains moribund and is unlikely to start improving until the jobs situation gets better.
During the inflationary 1970s, however, real estate proved itself as a potent store of value. The J.P. Morgan Chase asset-allocation group believes that QE2 will drive money into real estate and stocks since the Fed is eager to produce some sort of reflationary "wealth effect" that would spur more consumer spending. While it may be tough to go out and buy a house, a REIT fund can provide diversified exposure to the sector.
In terms of stock investing, tilting toward more economically sensitive stocks makes sense if the Fed is to succeed in reflating the economy. Technology, a group which has reasserted leadership in the past two months, is another favored sector among inflation fretters.
Underscoring the complications of investing in a Fed-driven economy is knowing what to do when the Fed's work is done. When will that be?
Not any time soon, it would seem. The Federal Open Market Committee has said for 14 consecutive policy meetings that it will keep short-term interest rates (nearly at zero) low for an "extended period of time."
Meantime, as they teach the young folks on Wall Street, don't fight the Fed.
Write to Dave Kansas at firstname.lastname@example.org