Tags: Merk | TIPS | QE | inflation

Fight the Inflation Boogeyman

By Wednesday, 03 October 2012 09:43 AM Current | Bio | Archive

Investors are concerned about inflation. But how can investors attempt to inflation-proof their portfolios? Buy Treasury-inflation protected securities (TIPS)? Short Treasury bonds? Stocks? Real estate? Commodities? Gold? Currencies? Or should investors regard those warnings about inflation as fear mongering?

Indeed, as the Federal Reserve announced its third round of quantitative easing (QE3), gauges of future inflation expectations spiked. In our assessment, the market reacted strongly as it became apparent that the Fed is moving away from its focus on inflation to a focus on employment. We believe the Fed wants to raise the price level so as to bail out millions of homeowners who are ‘under water’, i.e., those who owe more on their homes than the homes are worth. Fed Chairman Ben Bernanke considers a healthy housing market to be key to healthy consumer spending.

Judging from the market reaction to QE3, fears about future inflation are warranted. Having said that, market fears about looming inflation have calmed down a bit since the initial flare up. Could it be this calming of the market is due to the fact that the Fed is intervening in the TIPS market? TIPS are “inflation protected” Treasury securities that are linked to the Consumer Price Index (CPI). Investors buying TIPS do so in the hope that their purchasing power might be protected. When the Fed intervenes in the market to buy TIPS (or any other security for that matter), such securities are intentionally overpriced, raising doubt as to whether investors are truly “protected” from inflation.

It’s not just investors who now have more limited access to measuring inflation expectations — it’s also the Fed itself. By managing the entire yield curve (short-term through long-term interest rates), we believe the Fed has blindfolded itself, as it has taken away one of the most important gauges about the health of the economy. Aside from the Fed’s intervention in the TIPS market, the government is free to change the inflation adjustment factor employed in TIPS before the securities mature. TIPS payouts are adjusted using the CPI, which has seen methodology changes many times. When the recent debt-ceiling impasse was discussed, both Republicans and Democrats talked in favor of changing the CPI definition so that it would nominally live up to inflation-linked entitlement promises while clearly eroding the purchasing power of such payouts. Even without such gimmickry, the CPI might not be reflective of the basket of goods and services consumed by investors as they approach retirement given, for example, that healthcare might comprise an ever-increasing part of one’s spending. Alas, much of investing is about trying to preserve purchasing power and, alas, buying TIPS might not provide adequate protection.

If one is negative about the inflation outlook, why not simply short Treasurys, either directly or through exchange-traded funds (ETFs)? While we are pessimistic about the long-term outlook of Treasurys, it can be very costly to short them, given that — as a short seller — one has to continuously pay the interest of the securities one shorts. If one buys an ETF shorting Treasurys, the cost of the ETF is to be added. Shorting Treasurys might make sense for investors who are good at market timing. However, calling the top in major bubbles is rather difficult. Just reflect on former Fed Chair Alan Greenspan’s “irrational exuberance” speech years ahead of the stock market collapse in 2000. Similarly, those who saw the bubble in the housing market coming didn’t necessarily get the timing right.

If TIPS don’t provide enough bang for the buck and shorting Treasurys can be costly, what about buying stocks? Bernanke appears to use every opportunity possible to praise the benefits QE has on raising stock prices. While we agree that QE has pushed stock prices higher, it might be dangerous for the Fed to praise this link given that it raises expectations of more Fed easing whenever the markets plunge. For example, how many investors buy Cisco System shares because of the great management skills of CEO John Chambers relative to those who buy because of QE3?

We pose this question because stocks are rather volatile. Not only are stocks volatile, but the volatility of stocks can be all over the place. Historically, the annualized standard deviation of the Standard & Poor’s 500 Index hovers in the mid-20 percent range, with outbursts into the 40 percent range in 2008. So, why are investors taking on the “noise” of the stock market, when the reason they invest is because of QE? Indeed, our analysis shows that investors appear to be ever more chasing the next perceived intervention by policymakers rather than investing based on fundamentals. That’s not only bad for capital formation (these misallocations are summarily referred to as “bubbles” these days), but also suggests that we might want to look for a more direct way to take a position on what we call the “mania” of policymakers.

Talking about policymakers, you might not agree with them, but if there is one good thing to be said about our policy makers, it is that they might be quite predictable.

We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

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As the Federal Reserve announced its third round of quantitative easing (QE3), gauges of future inflation expectations spiked. In our assessment, the market reacted strongly as it became apparent that the Fed is moving away from its focus on inflation to a focus on employment.
Wednesday, 03 October 2012 09:43 AM
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