The financial markets are definitely not showing much direction overall but the relatively calm surface is hiding turbulent and conflicting currents not far beneath the surface. The Fund King System remains in a “risk off” stance with recommendations across our main portfolios all tending towards US government bonds (TLH & TLT), cash, gold and silver. None of the readings on these individual asset classes are particularly compelling…but they are positive. So, as we wait to see just how awful US 3Q GDP numbers might be, the System is not recommending any risky positions. What currencies do you want to be in? It looks like the US Dollar and Japanese Yen are the best for now. The Euro has staged a bit of a comeback on the completion of EU wide bank “stress tests” but is still weak. A bet on the Euro is certainly a bet on the health of the European Banking system which remains overly dependent on potentially fickle wholesale financing (as opposed to deposits). The Australian Dollar is also a bit weak largely due to a potential economic slowdown in Mainland China (a huge consumer of Australian minerals).

The currents underneath the surface derive from the powerful forces that are struggling to define the next phase of global economic development.

Option 1: Deflation

Long Term US Government Paper is attracting money from those who see the current lack of consumer demand growth as an intermediate trend and a signal that we will enter a period of sustained deflation. When the Global Financial Crisis started in 2008, analysts who suggested that the US or European economies might experience some of the deflation and stagnation that Japan has endured since 1990 were summarily dismissed. However, that dismissal now seems to have been premature. Even in the early 90’s, investors had a hard time believing that Japan would not shake off the slump in short order. The country that had given us the economic miracle, just in time inventory, quality circles and firms that could buy up Rockefeller Center and Pebble Beach would surely continue their inexorable rise as the leader of the dawning “Pacific Century” (now redubbed the “Asian Century”). Deflationary fears are also driven by the evidence that massive government stimulus combined with very accommodating monetary policies has not delivered as advertised. If the Fed is “pushing on a string”, then perhaps it has run low on viable options. With Middle Class America taking serious hits on income (high unemployment) and wealth (underwater mortgages), the deflation camp is betting on continued sluggish consumer demand. The main risk to a deflation geared portfolio is a change in consumer demand. Signs of a positive change in consumer demand will send investors scrambling out of Treasuries (and the US dollar) and back into riskier assets (High Yield, Equities and eventually Commodities).

Option 2: Inflation

On the other side of the debate are those who see governments (particularly in the US but also in Europe and Asia) increasing their weight in their respective economies. Governments are beholden to voters and usually choose paths that lead to the least amount of pain in the short term. That suggests a risk of currency debasement and sustained inflation. Debtors prefer to pay back money far in the future after inflation has worn away the value of future dollars. Since the big debtors include most of the G7 Governments and their Mortgage Paying Electorate, there is no doubt about which way political will is positioned. The fear of currency debasement is at the core of the Gold Trade. So, while both Gold and Treasuries have been moving up together over the past few years, their performance should diverge sharply once it becomes clear whether we are heading into deflation or inflation.

Option 3: Healthy Global Growth

And what about the middle road between these two outcomes…decent growth with inflation at 2-4%? That outcome is the only one on which very little is being wagered because it seems the least likely. This recession is different from what most of us are used to because it is due to a financial crisis, not the usual manufacturing inventory overstock. The NBER, the official arbiter of recession timing, has yet to declare an end to the recession which started at the end of 2007. Perhaps their caution, which was criticized toward the end of 2009, was justified after all.

What should investors do?

For now, one would be wise to follow the advice first given by Oliver Cromwell:

“Put your trust in God; but mind to keep your powder dry.”

There is no reason to embark on risky or illiquid trades now. Avoiding a nasty drop is just as important as participating in market rallies to the overall health of your portfolio. At best, you will rack up a big commission bill, at worst, you could get stuck in a position that looks wrong footed in the autumn. Despite all the promises from internet penny stock newsletters, this is not the right time to go chasing after “the next big thing” with any more than a few percentage points of your portfolio.


Filed under: CurrencyETFFixed IncomeInflation/DeflationInterest RatesMarket Psychology

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