It may have been the most foolhardy announcement of the American election campaign. In August, Republican candidate Mitt Romney said that if he became president, he wouldn't re-appoint Ben Bernanke as Federal Reserve chairman. Up until then, concerns about political impartiality might have held Bernanke back from acting ahead of voters going to the polls. But after that, what did he have to lose?
Last week, impending US election or no, Bernanke launched the third batch of American quantitative easing (QE). QE3 impressed even the most bullish investors. The Fed will print $40bn a month to buy mortgage-backed securities. The aim is to drive the price of home loans down from already low levels, and keep them there, thus aiding the nascent US property market recovery the only way the Fed knows how. Bernanke also promised to keep the federal funds rate (the American equivalent of the Bank of England base rate) at near zero until mid-2015.
That's a pretty aggressive response. The last two bouts of QE came at times of panic. The first bout followed the collapse of Lehman Brothers in 2008, when a deflationary slump seemed like a real possibility. QE2, in 2010, came at the height of one of the biggest panics over the eurozone. This time, the worst that can be said is that the US economy looks droopier than Bernanke would like.
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But it's not so much what Bernanke did, as the way he did it. This $40bn-a-month measure has no end date or target quantity. Instead, buying will continue until the "outlook for the labour market" improves "substantially". Most observers took this to mean that unemployment had to fall to at least 7% (it's above 8% now). Crucially, the Fed also said it will keep rates low until the economic recovery is entrenched. "We are not going to rush to tighten policy," said Bernanke.
In classical economics, there's a trade-off between inflation and employment. The closer you get to full employment (in other words, the greater the demand for labour and the tighter the supply), the higher inflation is likely to go. Bernanke is firmly coming down on the side of employment. This is him saying that the Fed will "do what it takes" to boost the American economy. This is QE infinity. This is QE until it works (employment goes up) or until it hurts (inflation rockets).
Will it work?
But does the Fed have what it takes? The market seems to think so. After the announcement, the price of US government bonds slipped back, and yields rose. As the Financial Times noted, "market expectations for US inflation over the next ten years rose as high as 2.73%... the highest... since May 2006".
But the Fed has been trying to boost the economy for some time. The fact that QE3 is even needed is reason enough to be cautious. Perhaps the biggest risk is that the Fed keeps printing money, only to reveal that the "Emperor has no clothes", as Capital Economics puts it. It may be that the only thing that can resolve the state of the global economy is time.
There are also some serious challenges ahead. The biggest domestic threat is the fiscal cliff'. During last summer's stand-off over the national debt ceiling, US politicians agreed on automatic' austerity measures that will come in from January 2013. Various tax cuts are also set to expire. If nothing changes, the US could see cuts and tax rises worth 5% of GDP kick in. That could send the economy back into recession, reckons the Congressional Budget Office.
Elsewhere, while the Europeans (with the exception of German central bankers) are gradually embracing the inflationary route out of the crisis, further eurozone panics are likely. The Spanish are reluctant to ask for a bail-out for a start. Every election over the next few years will be watched with bated breath for signs that voters are waking up to the fact that, if they want to retake control of their economies, they have to ditch the euro. Even creating inflation, let alone growth, might be harder than the Fed expects.
For one, China's collapsing economy will drag down the prices of most raw materials, regardless of how much money the Fed prints (see below). For another, devaluing the dollar might be more of a challenge than many anticipate. Bernanke is probably the most blatantly dedicated money-printer of all, but he has a lot of competition. Our own Bank of England governor Mervyn King is giving him a run for his money. Even the Bank of Japan has joined in, with this week's move to pump ten trillion more yen into its economy.
What we can say for sure is that Bernanke has firmly nailed his colours to the mast. He believes money printing will work he just has to do enough. So we can be confident that he will keep printing for as long as he can, and that markets will keep reacting to that.
Most pundits think that American inflation of 3% would stop him, but Steve Sjuggerud, writing in the DailyWealth newsletter, reckons the only thing that could really stop the Fed is if the inflation rate hit 5%. Of course, inflation hit 5% in Britain and the Bank of England didn't flinch. So perhaps even 5% is conservative.
But while given Bernanke's determination a nasty inflationary phase still seems the most likely endgame, it could be a while away given the obstacles he faces. So rather than bet big on inflation or deflation, we'd suggest that instead you buy what's cheap and avoid what's expensive. Here's what that means in practical terms for your portfolio.
Commodities
You might think the threat of inflation would be good for commodities. After all, commodities are real assets', not paper or financial ones. Normally we'd agree. But the same force that drove up resources prices China is now sucking them into the abyss. China has been responsible for the majority of the increased demand that drove commodity prices to record levels over the past decade or so. As China's economy has slowed, commodity prices have dropped sharply. But don't think for a moment that things can't get worse.
Peking University professor Michael Pettis spells it out on his blog (Mpettis.com). Commodity producers always take a long time to react to rising prices and start new projects. But when they do, they really ramp up production. The trouble is, there's a long lag between giving the green light to a new mine and the metal actually being produced.
Just as miners are slow to react to the initial rise in prices, they are also slow to react when they start falling. So just as the downturn in demand kicks in, you often see supply surge too. Morgan Stanley's Gerard Minack notes that, in each of the next seven years, "the increase in global supply [of copper] will be roughly equal to the increase in supply over the decade to 2011".
It's worth noting that the Fed's best efforts to reflate the housing market have not worked. The reason the US housing market is showing signs of recovery now is simple: it's one of the few global property markets to have endured a genuine correction.
American property is now attractive because it offers value, not because the Fed is printing money. By extension, the Chinese government is not going to be able to arrest the slide in commodities simply by throwing more stimulus' into the mix.
Anyway, as Pettis notes, "it doesn't matter where you agree or disagree" that China's economy will slow further. The Chinese economy is shifting its focus to being more consumer-led. So it will need "much less in the way of hard commodities". Pettis expects "certain commodities, like copper, will drop by 50% or more in the next two to three years".
Sean Corrigan of Diapason Commodities Management puts it still more bluntly: "China is still shot, whatever the apologists say". That means you should avoid industrial metals miners and avoid commodity-dependent emerging markets like Brazil and Australia. If you're up for taking a speculative bet, short the Australian dollar against the US dollar.
Stocks
Emerging markets are by and large heavily reliant on China and commodity markets. This is one reason we're not keen on them. They are also generally expensive. There are a few areas of potential interest India is still in trouble, and has a tendency to disappoint, but it is one of the few emerging markets that would unequivocally benefit from lower raw materials prices. But overall we'd keep your emerging-market exposure to a minimum right now.
As for developed markets, the years ahead are likely to be filled with unpleasant economic surprises, so it makes more sense to buy stocks that are pricing in at least some bad news, rather than ones that are priced for perfection. That's why we'd favour cheap markets such as Europe and Japan over expensive America.
As for Britain, we'd still favour companies with clean balance sheets that offer decent dividend yields you should build a watch list of candidates and buy when prices falter. As Jim Reid of Deutsche Bank puts it, in an environment facing an inflationary end-game punctuated with deflationary scares, the best strategy is "accumulation of core, higher-quality, real assets on dips. An income stream is also desirable. So higher-dividend, quality equities remain the favoured traditional asset class of choice".
Precious metals
The future for industrial metals looks grim. But not so precious metals. Gold is our favourite. Given that every major central bank in the world is printing money, fiat currency in general can only lose value compared to gold. Daniel Brebner and Xiao Fu at Deutsche Bank note this is likely to continue.
"A managed form of currency depreciation through various stages of quantitative easing or successive bail-outs by central banks of the banking system" is the most palatable option for developed-world politicians to get out of their debt messes. That's all "good for gold".
The Deutsche analysts value gold according to Gresham's Law (see below), by which bad money drives out good'. "Gold's value depends in large part on the degree of badness' of bad money." When bad money' or paper money is being devalued, as it is now, you would expect people's inclination to hoard gold to rise, along with the price of the yellow metal. "This is why the gold price has been appreciating over the past ten years." Have some in your portfolio as insurance against a financial disaster or uncontrollable inflation.
Silver is the other major monetary metal. It's a metal we were very keen on as a "buy and hold" play when it was below $10 an ounce several years ago. It still has a lot of potential, but you can expect a much wilder ride than with gold. It's one for the more adventurous investor who wants to top up their exposure to precious metals.
Platinum is primarily an industrial metal, but it's also unusually cheap compared to gold (it rarely trades below the gold price, as it does now). With South Africa by far the biggest source of the metal, it looks like a good bet on a supply-demand basis, given the troubles in the country's mining sector.
Energy
In the longer run, we suspect the oil price won't rise much higher. It could also fall a lot lower if the global economy continues to slow. However, concerns over Iran's nuclear ambitions and the potential for an Israeli strike on the country won't go away in the near term. So while we wouldn't be placing big bets on oil rising, we wouldn't short it either.
Elsewhere in the sector, we think natural gas is the energy source with the most potential in the longer run. The price in the US seems to have bottomed out, partly as a result of producers cutting back. We'll be looking at the sector in more detail in a forthcoming issue of MoneyWeek.
Trophy assets
There's a lot of talk about how you should buy wine and art to protect against growth in the money supply. Our view is that a slowdown in China is likely to hurt demand for wine and art and similar luxury real' assets. These cost you money to store, and they're also a magnet for scam artists. Unless you're an aficionado or enjoy collecting, we wouldn't bother putting these in your portfolio. If you're worried about growth in the money supply, buy gold it's as simple as that.
Bonds
Developed-world government bonds are at or near record highs (ie, yields are at record lows). They're just too expensive. They might rise further, but on balance the risks are too great that they won't. As a bond investor, does it make sense to own an asset that will suffer under the economic conditions that a nation's central bank is actively trying to create? If bond investors wake up to the fact that Bernanke cares more about growth than he does about their profits, they might start to rebel. So we'll keep avoiding them.
Index-linked government bonds are different, but note that the British government is consulting on closing the gap between the retail price index and the consumer price index, which could reduce payments on index-linked gilts. That's the kind of tricky move we can expect to see more of in future.
As for corporate bonds, their popularity makes us nervous. That firms have flocked to raise money from private investors on the retail bond market suggests to us it's the firms, rather than investors, who are getting the best of the deal. There are some interesting individual opportunities, but overall we'd have minimal exposure to corporate bonds.
Property
The biggest problem with property is getting diversified exposure. If you're looking for an investment property, we'd be looking at Germany (which is where all the loose money in the eurozone is flowing) and the States (where the housing market is now cheap). We still aren't keen on British property, but my colleague Phil Oakley reviewed real estate investment trusts (Reits) this week and found some offering good yields and solid balance sheets: The best way to invest in Britain's property market today.
Cash
It's still worth having cash in your portfolio. This gives you optionality' you can use it to pounce on cheap buys. With markets swinging between despair and euphoria, there'll be lots of those ahead.
Gresham's Law will drive up gold
Gresham's Law is named after the 16th-century financier Sir Thomas Gresham (1519-1579). It states: "When a government compulsorily overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation". This can be summed up as "bad money drives out good, when the exchange rate is fixed".
In its strictest sense it applies to cases where the metal in a coin is worth more than its value as legal tender. In this case, the good' money would be hoarded in favour of spending coins whose real' value was closer to their legal tender value. Deutsche Bank argues that, with today's paper money being devalued, it can be seen as bad' money compared to the the good' money of gold.
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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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