Fiscal Frustration Forces Rebalancing of Investments
Life + Money

Fiscal Frustration Forces Rebalancing of Investments


A torrential downpour replete with giant lightening bolts greeted investment advisors last week as they streamed into Morningstar’s annual investment conference in Chicago. And an apt welcome it was, given the fairly apocalyptic warnings they would soon hear from investment gurus about the long-term risks of U.S. fiscal deficits. “A burst of inflation is highly likely in the next decade” due to a “3-D hurricane of deficits, debt and demographics,” warned veteran financial analyst Rob Arnott. “Now is the time for hunkering down” and “buying inflation protection while it’s still cheap.”

Such dark thoughts ran like a river through the conference. And many of the featured speakers and hallway discussions were about finding ways to keep portfolios afloat in spite of slower growth in the short term and a looming inflation threat longer term. Rudolph-Riad Younes, who heads international equities at Artio Global Investors, suggests putting a part of most portfolios into commodities, particularly gold, and for the really rich, farmland. “If inflation returns, paper currencies will lose hands down compared to gold or farmland,” says Younes. That’s particularly striking, since gold just reached an all-time high, at least in nominal terms, of $1,260 an ounce.

For the short term, most speakers were relatively upbeat on stocks, predicting an upward if volatile ride over the next year or so. “We’re good for the next 18 months,” Bob Reynolds, president and CEO of Putnam investment, told me. “Corporations are in great shape. They have good balance sheets, low debt and good earnings.” Indeed, he thinks stocks may “take off” now that much of the uncertainty over financial reform has been removed. But longer term, he worries about slower growth, and a surge of inflation. Says Reynolds: “If we continue down the current path, we are going to be fighting inflation.”

Red Bull Economics
Inflation may be hard to see coming at this point, especially when a slow economy has left corporations with little pricing power, and labor with no leverage to raise wages. “At best we are looking at middling growth,” said Steve Romick, a long-time value investor and partner with First Pacific Advisors, who refers to the recent spate of fiscal and monetary stimulus as “Red Bull economics.” Says Romick: “The economy is really jacked up, and when the stimulus wears off, the economy can come down very hard.”

But while a hot debate still rages over whether the economy will dip into another recession or just slow down, there was broad consensus at the conference on one point: The biggest long-term risk to the U.S. economy is its massive government debt burden and Washington is ill equipped to deal with it. The U.S. is betting that “small tax increases, spending cuts and economic growth” will solve the problem, said Younes. But given the political climate in Washington, he gives that strategy only a “25 percent chance of success.” More likely, he sees the U.S. debasing its currency to reduce its debt burden, which means inflation down the road.

“In the 1990s, we had the dot-com bubble,” says Younes.
“Now we have a dot-gov bubble.”

Gold, Farmland and Other Inflation Hedges

Many analysts are arguing that gold and gold mining stocks still have a way to go because demand continues to outstrip limited supply. Besides strong demand for gold for jewelry from increasingly affluent emerging countries like China and India, there is growing demand for gold from central banks as an alternative reserve currency and from investors as a hedge against the loss of global purchasing power as the dollar and Euro weaken. Joe Wickwire, who manages the Fidelity Select Gold Portfolio, says gold is only in the “middle innings of a secular bull market.”

In addition to commodities, Arnott suggests hedging against inflation by buying Treasury Protected Securities (TIPs) and Real Estate Investment Trusts (REITs). He sees a 12- to 24-month window when such inflation hedges can be bought at bargain prices. “Buying inflation protection is cheapest when people are not worried about inflation,” says Arnott.

And what about stocks, which have historically been considered a hedge against inflation? Among the stock pickers, most of the focus was on international markets where growth is still strong, particularly emerging markets, like China and India, where governments are running surpluses and domestic demand is rising, and resource-based economies like Australia, Canada and even Russia. Several speakers also said they were finding opportunities among financial institutions in northern Europe, whose stocks had been unfairly punished by Greek debt crisis. As for the U.S., one of the most enthusiastic speakers was Hersh Cohen, chief investment officer at ClearBridge Advisors, who said he was finding bargains among big cash-rich companies with high dividends. That way even if earning growth weakens, you at least get the dividends.

Will Washington step up?
The bottom line for these investment gurus: U.S. stocks and bonds alone won’t be enough to save retirement plans if inflation roars back. U.S. investors need to be diversified with foreign equities, commodities, TIPS and other investments that are not particularly correlated with U.S. stocks or bonds. Of course, these gurus could be wrong, and Washington could skillfully maneuver to spur domestic growth, cut the deficit and avoid inflation. But most weren’t betting on it. And you may not want to either.