Given the turmoil in the Middle East and the earthquake in Japan, many market observers expected the market to have a bigger pullback. Instead, the market appears to be resilient to any "Black Swan" event. Instead, many keen market observers are beginning to put up the warning flags that big risks are ahead for investors.
For example, HSBC is cutting its growth targets and increasing inflation targets. The key area of concern is the large increase in commodity prices; never in history has there been this large of an increase in commodity prices following a protraction. The high commodity prices will lead to higher input prices and higher prices will begin to erode the confidence of both firms and households. HSBC sees the scenario play out this way with oil prices: higher oil prices will lead to a reduction in disposable income which will lead to a decrease in capital spending which will lead to a decrease in imports which will lead to a decrease in world trade. In other words, there will be a redistribution of wealth from high spending economies (i.e. the U.S. and Europe) to the high saving economies (i.e. developing economies).
As commodity prices continue to rise, Federal Reserve Governor James Bullard is calling for the Federal Reserve to draw up an exit plan of QE2. His rationale is the economy is doing alright, thus QE2 is no longer needed. Market observers are unsure of the impact of withdrawing QE2 will have on the global equity and commodity markets. Both of these markets have been benefactors of the low interest rates and cheap dollar that QE2 has produced.
While many investors are unsure of what the true effect of no longer having QE2 will be on the markets, two key investors are not investing in the dollar or U.S. Treasuries. The two key investors are Warren Buffett and Bill Gross. When asked about investing in U.S. Treasuries, Mr. Buffett responded by saying that in five-, ten-, or twenty-years down the line, the dollar's purchasing power will be eroded by the monetary policy being currently pursued. As a result, Mr. Buffett has begun to move out of U.S. fixed income assets. The assets remaining in his portfolio have short duration (i.e. short maturity). The price of short duration securities are less impacted by an increase in interest rates that long duration securities. Increasing inflationary expectations will increase interest rates, thus negatively impact the price of bonds. Bill Gross, the other key investor, has sold off all Treasuries in the portfolios he manages.
So, where does that leave investors?
To be perfectly honest, I do not believe there is a safe place for an investor to be. As a result, I would be hesitant to hold the US dollar and would prefer to be long the Euro and other emerging market currencies for the long-term The dollar is facing uncertainty as the leadership in Washington do not seem to want to tackle both old and new problems head on. Continued overspending will lead to more borrowing, and force the dollar to continue a downward trend. In the long-term, commodities will contine to rally. As a result, there will be increased investment in emerging economies. This will cause those currencies to continue appreciating against the dollar. Central bankers in those economies will need to react and will begin to increase interest rates. This will be a positive for the currencies of emerging economies, but will be a negative to the dollar.
As a result of a declining currency, average U.S. investors will need to hedge their investments. As I have stated before on this blog, I would begin to invest in high-quality U.S. stocks with strong franchises and high developing market exposure. First, companies with strong franchises will be able to pass on higher costs to consumers. Second, companies with strong developing market expsoure will benefit from a weaker dollar. Since the products of these companies will priced in dollars, products sold by U.S. based companies will look cheaper as a result of the weak dollar, thus increasing demand. In addition, when the non-US dollar sales are converted back into U.S. dollars, these sales will be worth more as it will take more U.S. dollars to purchase these other currencies. The net impact on these companies should be higher sales and profit, in addition to higher cash flow. Higher cash flow will enable these companies to increase dividends and repurchase shares.
As a sidenote, look for companies that will have the ability to grow dividends at a higher compounded rate than inflation. In this case, investors will increase their purchasing power.
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