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Positioning for Deflation or Inflation?

Economics is a very inexact science.  We can all feel the relief from asset prices that are 50% above the 2009 lows, but the uncertainty lingers like a thick and unforgiving fog.  The economic recovery has come, but it seems tenuous at best.  We were told long ago that the agency mortgage backed security purchase program that was put in place by the Federal reserve during the depths of the financial crisis would be ending in March.  This unwind would be a signal to the markets that the Federal Reserve would be lifting its financial support of the markets and would specifically unwind the government support of the mortgage markets and long-term interest rates.  Unfortunately,  Freddie and Fannie have recently announced that they will buy out all loans with 120+ days of delinquency over the next three months which would effectively put $175B into investors hands to be reinvested in the MBS market.  Take away support in one arena and replace it in another.  Just a shell game.  More uncertain signals from the Fed.

The reason I bring up this rather interesting Federal Reserve shell game is because that even they are having a hard time believing in the strength of the recovery.  This amount of financial intervention is unprecedented, especially when the governments around the world are running such large deficits.  So how do we interpret these conflicting signals?  On one hand, the amount of liquidity pumped into the financial markets is astonishing and seems like it should lend itself to a highly inflationary environment.  On the other hand, unemployment in developed nations is incredibly high and true consumer demand seems far away.  How can debt-burdened, unemployed consumers with significantly deteriorated net wealths find haphazard banks that will let them keep the economies of the world propped up?

I very much despise pontification of economic predictions and will leave that to the water-cooler based conversations of self-righteous hobby economists.  I honestly do not know what the outcome will be and that makes it a difficult environment to navigate.  From the standpoint of a person or institution that would like to maximize returns and minimize risks, the dichotomy of outcomes lends itself to very different investment philosophies.  An investment thesis of continued government, corporate, and personal de-leveraging would lend itself to a portfolio of safer fixed income investments.  Investment Grade Corporate bonds with a yield of over 5% would seem like a bargain if long-term US interest rates fell to 3% (LQD).  If we believe that the growth prospects going forward are real and that the excess liquidity will find a home then emerging markets (EEM,FXI) for growth and commodities for inflation protection (GLD, DBC) seem like good choices.

You might be thinking that is fine, but he just said that either outcome could happen so how do I prepare for both?  The realistic analysis is that you cannot.  The way that I like to look at it is to assign probabilities.  The likely scenario is that the Federal Reserve will eventually get what it wants and restart the engine.  If things proceed too quickly, then we will set ourselves up for a crash but if things slowly get better then we should see a devaluation of the dollar with medium inflation, much higher interest rates, and a stagnant but volatile equity market.  I assign a 60% chance to the latter and a 20% chance to the next bubble.  It is possible that we muddle along as we are currently doing for the next few years (15%) or that we actually experience a Japanese deflationary conundrum (5%).

From my vantage point, that leaves me with an 80% chance of higher interest rates, volatile equity prices, devaluation of the dollar, and slow to medium growth.  This has coerced me into an income oriented approach with inflation protection overlays.  I like high-quality investment vehicles that will pay back relatively high income with diversified sources (LQD, VNQ,PFF,PGF) and global stocks with strong country diversification and dividend growth.  In addition, I like the idea of protecting my buying power (DBC,GLD,TIP, AUD,NOK) while protecting against rising rates (short Euro$,Short Treasury Futures, Short TLT).

Unfortunately, the investing environment will not be exciting for some time to come.  It is time to be somewhat defensive, but invested and protected against the tail event of inflation.  Large crashes come on the heels of mass exuberance, not in a world of consistent uncertainty.

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