Analysis from AdvisorAnalyst.com

Economic Threats and Financial Opportunities

Confused about what's in store for the economy? The long-in-the-teeth rally in equities, falling U.S. treasury bond yields, and record gold prices reflect both the uncertainty, and the conflicting wagers on inflation and deflation. It appears we're at an inflection point, the outcome of which will depend on how economic policy makers act. The debate as to what happens next rages on.

Examine what two well-known fund managers with opposing views, Jim Rogers, an inflationist, and Eclectica's Hugh Hendry, a deflationist, are doing. These two are superlative at risk management, and are also high-conviction investors.

Jim Rogers has been an inflation zealot, arguing in favour of investing in gold and commodities for the better part of this year.

… Despite gold's potential, I think I will make more money in other commodities such as silver, cotton, or coffee – all of which are terribly depressed. …

"This is one of the few times in my life I have not had shorts anywhere in the world. I have also not had a lot of longs in the stock market because I've chosen longs in commodities and currencies. I have kept away from shorts because there is a gigantic amount of money being printed and it has to go somewhere. I thought some of it would end up in the stock market, and it has."

Hugh Hendry, on the other hand, argues that the era that is upon us will be deflationary. He contends that policymakers have sold us a fake; recovery, that is. Hendry says, it appears the U.S. is turning Japanese. He believes 30-year U.S. government bonds, and other beneficiaries of yield curve flattening will benefit from a return to risk-aversion and long-term massive deleveraging that he sees coming.

Now remember I have been describing a positive macro scenario: a world in which low interest rates make the debt load manageable and that we muddle through with lower growth rates in nominal GDP. But clearly the consequences for corporate profitability are very poor. The alarming thing is that my opponents (see Ferguson et al.) believe that government bond yields are going much higher. Effectively, the world's bond vigilantes are going to punish the Fed and tighten monetary policy. It is almost as if the world's greatest speculators are agitating for their own demise. It is my contention that the leverage of the economy is only tenable if interest rates stay low and yet, whilst I believe some of them agree, they still fervently expect a rise.

While I do not wish to see Hendry's deflation arguments come true, I'm afraid that his is the more compelling case, given that we are in the midst of a perplexing dilemma that U.S. policy makers have yet to address. How will America sustain its economy if its overwhelming indebtedness is not somehow reduced?

On the other hand, however, there is a possibility Rogers and Hendry are both right, at the same time, when you couple the balancing forces of a zero interest rate USD carry trade, along with domestic deflationary pressure. That, however, is material for another story.