It is high time for our political leaders to make some key decisions. And that translates into large uncertainties for investors that have held the market in a range and with low volume.
We do not know whether “Cap and Trade” legislation will pass the Senate and we do not know whether and any healthcare bill will pass through Congress, or what that bill might entail. And these two issues are paramount for the future of America.
As we discussed earlier, cap and trade could cause incremental costs in energy for all of the United States, particularly in all carbon-based generation of electricity. Increasing these costs will make carbon-based energy less competitive with alternative sources, like solar and nuclear. The benefits of this legislation will be less carbon emissions, cleaner air, less dependence on imported oil and the creation of new jobs in the alternative energy sector.
However, this all comes at the expense of jobs in the traditional energy sector, which is currently the backbone of our energy policy. It also means higher job losses in the rest of the economy due to higher energy costs. Remember that the United States is the “Saudi Arabia of coal,” given its abundance here.
All of these uncertainties are huge, as are the stakes for a multitude of sectors. I have been surprised by the unpredictable decisions of our legislators many times. In addition, legislative add-ons that tack hundreds of pages onto a bill right before it comes to a vote make prior analysis nearly impossible. Therefore, unless the outcome is almost a foregone conclusion and the details are clearly spelled out well beforehand, making strong bets on their legislative outcomes is just plain gambling.
The unemployment rate rose to 9.5% in June as the economy shed 467,00 jobs. That’s up from 322,000 in May. Jobs are a lagging indicator and tend to peak well after the economy has peaked. But they are the best coincident indicator of economic activity.
Warren Buffet recently said that he has not yet seen any green shoots in the economy. Conversely, General Electric Co. (NYSE: GE) Chief Executive Officer Jeffery Immelt said that all the pieces are in place for a recovery in the United States. Yet the only areas of strength he mentioned were abroad: China, some areas of the Middle East and other emerging economies.
But what we can all agree on right now is that there is no inflation in sight, despite the massive amounts of quantitative easing from the U.S. Federal Reserve. But it won’t be long before inflation does rear its ugly head.
Like the people in Germany who were deeply affected by hyperinflation, I remember living and analyzing companies in Argentina in the 80s with inflation rising at a rate of 1% a day. It was not fun, and the distortions to economic activity and financial statements were amazing.
Although the Fed has repeatedly indicated that it is ready to remove the monetary stimuli at the appropriate moment in an aggressive-enough fashion so as to preclude an inflationary spike, neither we can be sure that the central bank’s actions will meet with immediate success.
Federal Reserve Chairman Ben S. Bernanke is very capable and his resolve gives me comfort, but as former Fed Chairman Alan Greenspan told us when he was running the central bank, there are important variables in monetary policy that the Fed cannot know for sure: Among them are the lags between the Fed’s actions and the response in the economy and the precise sensitivity of the economy’s response to the Fed’s actions. It is like steering a large transatlantic ship while watching in the rearview mirror. By the time you see an iceberg, the ability to reverse or alter the course is very limited.
If we observe that the level of both monetary and fiscal intervention in the economy is at historic highs, then we have to understand that applying the just doses of intervention and reducing those doses as the economy gains a “self-sustaining” pace is a very tricky exercise. Even allowing for the best of intentions and the immaculate professional abilities of the Fed, this will be a very difficult task to pull off. And what is self-sustaining growth, anyhow?
We also need to understand that the current reflationary policy, which was employed to prevent the country from falling into a deflationary spiral, is actually seeking to create a little inflation. And it would be unpardonable to see the country fall back into a double-dip recession after all this intervention, should the Fed pull on the reins too soon.
In fact, the Fed and the Treasury Secretary Timothy F. Geithner have repeatedly led us to believe that they intend to see the recovery ingrained before withdrawing significant amounts of stimuli. It makes all the sense in the world. The logical implication is that they would rather see an unpleasant reading or two on the inflation front than see an unpleasant reading on the growth side. It is a very difficult situation to manage and they are not perfect.
So right now, when inflation expectations are well subdued, it is a good idea to add a position in Treasury Inflation-Protected Securities (TIPS). The easy way of doing this is by buying the iShares Barclays TIPS Bond Fund (NYSE: TIP).
All of these pending uncertainties that I mentioned are adding to the traditional summer doldrums and we are seeing very low stock trading volumes. So we are going to take advantage of the situation to get a good valuation on these bonds well before inflation expectations pick up.
Also, adding bonds to the portfolio has a stabilizing effect. And the two traditional worries with bonds: A drop in the value of the U.S. Dollar and an increase in inflation are actually hedged, at least in part, with TIPS. Because inflation is fully hedged as the principal is indexed by the consumer price index (CPI) index.
Recommendation: iShares Barclays TIPS Bond Fund (NYSE: TIP) at market (**).
(**) - Special Note of Disclosure: Horacio Marquez holds no interest in the iShares Barclays TIPS Bond Fund.
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