2011: Year of the Yellow Brick Road

Axel Merk, Portfolio Manager, Merk Funds

January 6, 2011

The Wizard of Oz would be proud of our policy makers: perception may be reality when it comes to investor confidence, even if we live in a fairy tale. However, investors that can afford to build a yellow brick road paved with gold may outshine those who build theirs with magic.

Let's enjoy the dream for a moment: the Federal Reserve (Fed) has sprinkled money on the economy, Congress has kept taxes low and we see signs of a recovery. A recovery driven by consumers with more disposable income. Where do they get it from? The reduced payroll tax? Maybe, but how about all the money consumers have at their disposal now that they have stopped paying their mortgage? What a wonderful life this must be! Because the Fed doesn't quite believe in the recovery, we believe QE2 will run it's course - Fed Chairman Bernanke has repeatedly stated that one of the grave policy mistakes during the Great Depression was that monetary policy was tightened too early. He appears committed to not letting history repeat itself; investors may want to trust him on that, as well as his commitment to push inflation higher. Ultimately, the Fed would like to engineer higher home prices so that consumers are no longer "under water." The challenge the Fed has, of course, is that while it can create asset inflation, the Fed has a difficult time influencing which assets inflate. Having said that, the Fed has at least some success: easy money has pushed at some company’s valuations higher, just look at Facebook, now valued at $50 billion, which may bode well for Palo Alto real estate. This is the Fed's contribution to the wealth gap: those with assets may do well under Bernanke's leadership, but don't expect a boom in underprivileged neighborhoods, unless someone convinces Facebook to relocate there.

Congress in the meantime will do what it does best: talk. There will be lots of it. Specifically, the debt ceiling may be the talk of the day, month and year. The new spirit amongst Republicans is to stop wasteful spending. And what better opportunity but to raise that point to appease voters this year. Granted, talk is cheaper than spending and indeed some spending projects may be halted. But let's remember that the grand compromise on tax reform did not require anyone to make tough choices. Washington wizardry is in full swing, make no mistake about it. After all this talk, we believe odds are extremely low that policy makers will wake up from the dreamworld and engage in urgently necessary, real reform required to stop the US from going down the path of Greece. While we are not there now and don't need to go down this route, all it would require is for policy makers to close their eyes, click their heels three times and say "I want to wake up; I want to wake up; I want to wake up!"

Don't look for the Fed or Congress to disturb the dream. The bond market may need to be called upon to rattle us. As the first signs, investors my interpret falling bond prices as a sign of economic recovery; but as the selloff may continue, the chief Wizards may be called upon to do something about those mean speculators that dare to wake us up from our dreamworld. Think volatility, think falling dollar. Think you wish your yellow brick road was paved in gold. But if enough believe in the dream, we might be able to keep on dreaming. Unfortunately, little has worked out the way our policy makers have wanted, so at the very least, investors my want to consider taking into account the possibility that we have woken up from this fairy tale.

It turns out that Bernanke's dream has real implications for the rest of the word. Asia is waking up with a hangover called inflation. Much of Asia has been importing U.S. monetary policy; given that the U.S. is curing its disease with the virus that created the disease in the first place (cheap credit), Asia has been catching a cold. Aware that a cold can turn into pneumonia, Asia has been struggling to neutralize the disease. In the spirit of keeping the dream alive, China is getting creative: deploying its vast reserves to invest in Greece; the latest proposal is to buy Spanish bonds. The beauty about this latest initiative - for China anyway - is that Greece has been, and Spain may be willing to sell important infrastructure that allows access to the respective ports. However, as inflation is picking up steam, more earnest measures may need to be taken, most notably a further appreciation of Asian currencies.

Indeed, while the US is in denial about inflation - after all wages are not budging -, the rest of the world has started to tighten monetary policy - that includes the eurozone where hundreds of billion in euros have been mopped up. This increasing interest rate differential has contributed to a rather weak U.S. dollar, only masked by a wobbling euro.

Talking about the eurozone, the bond vigilantes have already arrived to wake up European governments. It may only be a matter of time before the U.S. gets it's wakeup call. We have seen the drama unfold in Europe - the U.S. promises to be no less "entertaining." In our assessment, the question is not whether there will be bailouts for some states, but what strings will be attached to them. Let's also remember that the U.S is more vulnerable because of its current account deficit; the treasury market may be at risk of following the municipal bond market's decline. The U.S. situation particularly concerns us since Bernanke has shown a greater willingness to use the printing press to touch up problems than the European Central Bank (ECB).

In the meantime, Europe has wiped its eyes and is now wide awake and alert. In Europe, this doesn't translate to swift action, but may well lead to a process in which weaker states cede control of their budgets in return for aid. While not a perfect process, when coupled with expected restraint from the ECB, this could well turn the euro into a champ this year. A widely disliked investment such as the euro may hide a lot of value.

Overall, we see the world as increasingly unstable. U.S. policies are likely to rattle the rest of the world, while not fixing domestic issues. By all means, the Fed has to worry about the U.S., and cannot be held responsible for all the ills of the world, but we happen to believe that a more prudent Fed policy would also be in the interest of the U.S.

As far as gold is concerned, the continued concerns over sovereign solvency - not the eurozone in particular, but globally, combined with the U.S drive to achieve growth at any cost, make the yellow metal worth considering. What's in your vault? Is your yellow brick road made of dreams or gold? Just because policy makers are dreaming, doesn't mean investors need to.

Currencies and commodities may well dominate headlines yet again. If nothing else, they will be in the news because of the ongoing volatility we are likely to see in the market. We also expect continued active participation by policy makers. This may bode poorly for traditional portfolio diversification, as asset classes may move in tandem – both up and down – when trillions are thrown at the markets.