Analysis from AdvisorAnalyst.com

Which Way Now? Hard Assets or Government Bonds?

The debate in the market between inflationists (majority) and deflationists (minority) continues to complicate investors' ability to make decisions about where to deploy funds.

During the course of the year, inflationists benefited from the tailwind provided by the declining value of the dollar. The rally in risk assets came thanks to Bernanke's deflation-busting policy, and, ironically, therefore, as long as the news remained dire on GDP growth and unemployment, we could count on interest rates to remain around zero percent, and the dollar to continue lower as faithless investors ditched it.

For nine months, the dollar declined as the market put risk back "on." At the very beginning of the rally, in March 2009, the market's mood was very dark. The genesis of the rally was the short covering of bank stocks and financials, and the full scale launch of the dollar funded carry trade, mostly taking place in institutional and hedge fund trading rooms. Except for the wiliest, it most certainly was not driven by retail investors. The retail investor is usually late to the party once fear of missing opportunities sets in.

The rally in the dollar as of late November has confused the inflationist view as the tailwinds appear to have reversed. This has been, and remains a difficult time to make risk-based investment decisions.

Howard Marks, the legendary founder and manager of $67-billion, L.A.-based Oaktree Capital, has recently penned his highly-anticipated thoughts in his latest letter to investors, on what he sees as immediate concerns.

First off, he states it is "indisputable" the market has gotten way out in front of fundamentals, challenges the veracity of the economic recovery, the sustainability of the Fed's policies, and decision to zero interest rates, and points out that although businesses are profitable as a result of cost-cutting, it does not translate into higher GDP, since so many businesses are simply doing better as a result of employing less labour. Marks also discusses China and its importance as a source of funding.

Marks does not go as far as to predict inflation, but he is worried about it. He details the scenario under which it manifests itself, much like 1973-74, and ultimately highlights Paul Volcker's success in finally reining it in by jacking up interest rates to the 20-per-cent levels.

He says that if you are worried about inflation, devoting 10-15% of assets towards inflation related bets is like doing nothing at all. To be effectively invested in advance of these macro forces, you have to devote 30-40% of your assets. "Few people are," Marks says.

Marks suggests investors look at TIPS (Real Return Bonds in Canada), gold, commodities, and real estate (at the right price?), foreign currencies, making investments denominated in foreign currencies, buying securities of companies that can pass on prices and buying companies that own the commodities or assets denominated in foreign currencies. (There are more choices, but its an exhaustive list, so read the letter).

Gary Shilling, on the other hand, recommends six areas to buy and 11 to sell in his latest letter to investors. His first recommendation is to buy treasury bonds, a recommendation he has held to since 1981, when the opportunity was greatest. In the letter he points out that treasury bonds were the best performing asset in the 80s and 90s, and have been even better since then during what was the longest equity bull market.

He predicts treasury bond yields will go lower (a deflationist's bet) as he believes that instead of flooding the market with cheap dollars, banks which borrowed money from the Fed will repay the government. He also believes that consumers will warm to savings rather than resume the past consumption trend, and the savings trend will aid the U.S. government in taming its deficits. Shilling says, "If we're wrong, it will take at least several years to eat up global excess capacity during which the ever-inflation-wary Fed will no doubt remove the excess bank reserves, as Fed officials have already indicated."

Deleveraging is deflationary, as it takes money out of assets and repatriates it to the balance sheets of lenders. It's also very bullish for the dollar.

He also recommends buying income producing securities such as utilities, defensive consumer staples and food stocks, small luxuries producers, the dollar, and euro-dollar futures.

In the investments to avoid column, sell U.S. stocks in general, homebuilders and related stocks, selected large consumer-discretionary stocks, consumer lender stocks, many low- and old-tech capital goods manufacturers, junk bonds, commercial real estate, most commodities, developing country stocks and bonds, and any real estate you're planning to sell, he says do it "yesterday." It's an onerous list.

Whether you agree with Marks or Shilling, both provide lucid, and un-sensational perspectives on each side of the inflation/deflation debate. Shilling's most compelling points are that banks have hoarded the cash issued by the Fed, rather than lend it, and consumers will consider it vogue to deleverage and save in 2010, and the dollar will rally.

By the way, an unwinding of the dollar-funded carry trade would raise the dollar's value as traders cover their short positions. The question is how long can the unwound carry trade in the dollar sustain the dollar's value if the government is unable to rein in the money supply and deficits, in rising rates scenario.

Marks does not want to predict the future, as the future holds many unanswered questions. But, on the question of where rates are likely to go, Marks' says "up," as there is so little room the other way.

Either way, I urge you to read both letters carefully from front to back for the insight that you can garner from them. In my humble opinion, these are two letters you will want to read in their entirety, if you haven't already.