Republican Victory and Fed Easing Means It's Time to Shift From Commodities to U.S. Stocks

[Editor's Note: Money Morning has provided investors with some of the best investment-related midterm-election content on the Internet. And we're not finished. In today's lead story, author, columnist and political guru Martin Hutchinson explains where investors need to put their money now. In a related story (available by clicking here), Money Morning highlights the three U.S. defense players most likely to benefit from Republican gains.]

The U.S. economic and investment world has changed fundamentally in the last 48 hours from two key events:

  • The massive Republican victory in Tuesday's midterm elections.
  • And the $600 billion worth of bond purchases by the U.S. Federal Reserve.

These two events have changed the trajectory of the U.S. economy, probably for the next two years.

As investors, we'd better adapt to them - and fast.

A New Political Landscape

The GOP victory in the U.S. House of Representatives was truly historic.

With more than 240 members out of the total 435 after Tuesday's midterm elections, the GOP will be better represented in the House in the New Year than in any Congress since that of 1947-48.

In fact, there will be at least 10 more House Republicans than in any of the Congresses of 1994-2006 in which the GOP had the majority. That's important: To the extent the House can do anything on its own, the Republican caucus should have the votes to do it, without excessive pork-barrel bribery of fence-sitters.

That wasn't true from 1994-2006. Indeed, the disciplined majority of 1994-96 soon gave way to an "every-man-for-himself" mentality in which only two things mattered: getting re-elected, and grabbing major pork for your district.

Two GOP leaders of that time – House Speaker Dennis Hastert and Majority Leader Tom DeLay – certainly didn't help matters, but they were severely hampered by the small Republican majorities.

Of course, the bad news for Republicans is that they came up several seats short in the U.S. Senate, meaning the GOP only gained control of the House. That reality – and the fact that Barack Obama remains president – likely means that few Republican policies will actually become law.

However, two areas in which the new House can have a genuine effect are fiscal policy and monetary policy, which coincidentally are also the two economic policy areas that have damaged this economic recovery.

Let's look at them both.

Help Wanted: New Policies Inside the Beltway

In terms of fiscal policy, Republicans are determined to cut public spending after its bipartisan bloating since 2007 under presidents George W. Bush and Obama.

Cynics will claim that the Republicans notably failed to cut spending in 2001-06, but they at least restrained it under better leadership in 1994-98, and have a good chance of at least denting its growth now.

President Obama can veto spending bills, but the public and market cost of vetoing spending bills that don't have enough bloat when there's a deficit of $1 trillion or more will make it difficult for him to do so, except at the margins. Thus, spending will come down as a percentage of gross domestic product (GDP), freeing up resources for the private sector.

There may be some tax cuts, too, but these make little difference.  Provided the country's credit remains good, the difference between taxes and borrowing is only one of financing; it's the wasteful public spending that is a true drain on national resources.

That brings us to the second key event of the last 48 hours – so called "QE2," which is the Fed's decision to buy another $600 billion of U.S. Treasuries in the next eight months.

That decision is sheer lunacy.

We're talking about having the central bank print $600 billion of new money, which it would then devote to the least-most-productive option in the U.S. economy – financing the government deficit.

The theory is that all this money will drive down interest rates, forcing banks to finance small-business growth – which, in turn, would create jobs.

But there's a problem with that assumption: In today's global marketplace, there are too many alternatives for banks seeking higher yields. It's far more likely that the money will end up fueling commodity speculation and emerging-market inflation.

Indeed, shortly after the Fed announced its plan, José Sergio Gabrielli
, the chief executive officer of Petroleo Brasileiro SA (NYSE ADR: PBR), told commentators on the popular financial cable channel CNBC that "more liquidity is good for Petrobras" - especially since, for one thing, that ‘liquidity" increases oil prices.

But that's hardly the purpose of the exercise. It would be much better for the Fed to buy $100 billion or so of small business loans directly from bank balance sheets.

True, that would expose the Fed to risk. But the Fed is already exposed to risk.

If Fed Chairman Ben S. Bernanke really wants the U.S. economy to recover, he should push short-term U.S. interest rates up to a more normal range of 2% to 3%. That would puncture the commodities bubble, make U.S. business lending more attractive compared with foreign lending, and induce U.S. consumers and investors to begin rebuilding the depleted U.S. savings base. After all, if interest rates are zero, and the inflation rate is running at 2% to 3%, what's the incentive for anyone to save?

However, Bernanke has shown us over the past five years that he is a fanatic. He won't raise interest rates unless he is forced to do so.

That's where the new Congress is again interesting. It can't get rid of Bernanke - he's in office until January 2014. However, congressional leaders can harass him mercilessly, using repeated subpoenas and seemingly endless hearings to do so.

Don't forget – there's actually a small faction of the GOP that wants to abolish the Fed altogether. And a larger group wants to go onto a "gold-standard" type of arrangement, or pass statutes to "Volckerize" the Fed, forcing the central bank to run a much tighter monetary policy.

Beyond these, it's likely that a majority of the GOP thinks interest rates should be higher. That's certainly true of Kansas City Fed President Thomas Hoenig – who vehemently protested Wednesday's decision to ease – as well as several other regional Fed presidents who serve on a rotating schedule on the central bank's policymaking Federal Open Market Committee (FOMC).

Moves to Consider Now

How does this all play out come January, when the new Congress takes office?

First, there's a good chance that we'll see at least some reduction in the U.S. deficit.

Beyond that, there's also a very good chance that the new Congress will bring pressure on the Fed to stop buying U.S. Treasuries and to increase interest rates.

That won't work immediately. But it will eventually be good news for the U.S. economy. It will also be very good news for our U.S. investments, except for those in banks, which have waxed fat off the mistaken Fed policies.

Conversely, as January approaches, we may want to start thinking about lightening our positions in commodities, gold and shares that benefit from their continual price rise.

The best investment returns are made by anticipating major economic change before it happens.

The political and Fed moves of the last few days may bring such a change in 2011, and we should be ready for it.

Actions to Take: There are two important categories of actions to take – one direct and the other indirect.

Let's start with the category of "direct" moves to make – since they have to do with your investment holdings.

As Hutchinson notes, the "best investment returns are made by anticipating major economic change before it happens." The midterm election results and the Fed easing of the last few days will bring changes in the New Year – either directly, as in the case of the elections – or indirectly, as we'll see from the backlash that the central bank's "QE2" strategy could bring.

If there are some U.S. stocks that you've been watching, it may be time to take another look. And if you've listened to Hutchinson, and profited from the calls he made when he urged investors to buy gold, it may now be time to take some of those profits off the table, using them for other investments, or as a cache of cash for future opportunities.

The political and Fed moves of the last few days may spawn such opportunities in the New Year. And, as Hutchinson states at the close of today's column, investors "should be ready" for them.

The "indirect" moves investors should make were covered in an earlier Hutchinson column – one that ran just ahead of Tuesday's midterm elections, in fact. But they relate to this latest column – in fact, the moves he recommended in that earlier opinion piece could easily hasten some of the profit opportunities that he's detailing today.

In a column titled, "An Open Letter to Washington: How to Fix the Deficit and End the Bush-Tax-Cuts Debate," Hutchinson urged investors to write to their elected representatives, and to recommend tax and budgetary changes that would benefit the U.S. stock market and U.S. economy.  There was a hugely positive response to the article, with many respondents letting us know that they'd forwarded the column and cover letter to Congress. Even readers who debated some of the points recognized that there is a need for change and offered recommendations of their own.

With the election over, it's time to remind those who retained their seats in Congress that we, as investors, demand action. And Hutchinson recommends what some of those specific actions should be in a column and a prepared cover letter that can be easily passed along to your elected representative in Congress.

In fact, once the new officeholders are sworn in and take up their new jobs in Washington after the first of the New Year, it may well be time to remind them, as well.

But don't worry, we'll make sure to help you at that time, too.

[Editor's Note: If you have any doubts at all about Martin Hutchinson's market calls, take a moment to consider this story.

Three years ago - late October 2007, to be exact - Hutchinson told Money Morning readers to buy gold. At the time, it was trading at less than $770 an ounce. Gold zoomed up to $1,000 an ounce - creating a nice little profit for readers who heeded the columnist's advice.

But Hutchinson wasn't done.

Just a few months later – we're now talking about April 2008 - with gold having dropped back to the $900 level, he reiterated his call. Those who already owned gold should hold on, or buy more, he said. And those who failed to listen to him the first time around should take this opportunity to remedy their oversight, he urged.

Well, we all know where gold is trading at today: Yesterday's (Thursday's) surge of $54 an ounce puts it on the doorstep of $1,400 an ounce.

For investors who heeded Hutchinson's advice, that's a pretty nice neighborhood.

Investors who bought in after his first market call are sitting on a profit of as much as 82%. Even those who waited, and bought in at the $900 level, have a gain of as much as 65%.

But perhaps you don't want just "one" recommendation. Indeed, smart investors will want an ongoing access to Hutchinson's expertise. If that's the case, then The Merchant Banker Alert, Hutchinson's private advisory service, is worth your consideration.

For more information on The Merchant Banker Alert, please click here. For information about Hutchinson's new book, "Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System," including how to purchase the book at a 34% discount, please click here.]

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