Thu, 4 Oct 2012
Recent Fed action has laid the foundation for an inflationary environment in the U.S., and those looking to protect their portfolios should take a hard look at currencies, says Axel Merk of Merk Investments.
Christine Benz: I am Christine Benz, and I am here at Morningstar's ETF Invest Conference. I am joined today by Axel Merk. He is the president and chief investment officer of Merk Investments, and he also runs a number of currency-focused funds.
Axel, thank you so much for being here.
Axel Merk: Great to be with you.
Benz: Axel, you recently wrote a series of provocative pieces about inflation, really saying that you think the Federal Reserve's latest round of quantitative easing will be inflationary. Let's talk about your thesis there, why you think QE3 will lead to higher inflation in the years ahead?
Merk: Sure. First of all, I don't think it really matters whether we're right or not; it matters whether there is a risk that we're right. If you think there is a risk that not everything at the Federal Reserve will work according to plan, well, take it into account in your portfolio allocation. But more to the point, QE3 cuts the link between monetary policy and inflation and shifts the focus over to employment. What the Federal Reserve wants to achieve is that whenever we have good economic news come up, they don't want the bond market to sell off.
In the springtime, we had a couple of weeks of good economic data, and the bond market plunged. Those are headwinds that [Fed chairman Ben] Bernanke doesn't want. He especially wants mortgage rates to stay low. He wants long-term bond rates to stay low. The way you do it is you promise to keep buying Treasuries for an unlimited amount of time until things improve, and particularly, you shift the focus over to employment, and we'll see more of that.
We just had the Federal Open Market Committee minutes that said, well, how about some numeric targets. The reason they don't publish it right away is because you have the unemployment rate and the labor participation rate. But importantly, as you shift from fighting inflation to trying to lower unemployment, you want to have inflation. You want to push up the price level to bail out homeowners, and so if people don't pay off their debt, if you don't want those foreclosures, you have to push up the price level. That's what Bernanke wants. Don't fight the Fed. Inflation is here to come.
Benz: So, just to play devil's advocate, there has been at various points in time some hand-wringing over inflation, and it really hasn't materialized. Inflation over the past several years has stayed within normal range. Why do you think this latest round of easing will be more inflationary than what came before?
Merk: Well, the things you buy at Wal-Mart and don't need haven't gone up in price, but the cost of health care has gone up, the cost of education, and the price of gold. It's a bit like a frog in a boiling pot. We don't see inflation, but it kind of feels a little iffy, and by the time you notice it, it might be too late.
The dollar has gone down quite steadily in recent years, and over the last 30 years, over the last 100 years. The key thing is here, we have the better printing press than the rest of the world. Gold has been quite highly correlated to the printing press around the world, and ultimately we will kick the can down the road just as everybody else is doing.
If you're expecting with the election coming up, the focus on entitlement reform, well good luck, no matter who wins, having the majorities in Congress to achieve those. And so the path of least resistance is inflation: [giving] normal-paying people what you promised them, but eroding the purchasing power of that. We just have too much debt in the world, and inflation is quite likely, in our view, part of how these issues will be addressed.
Benz: You also think, though, that the standard inflation-fighting investments--Treasury Inflation-Protected Securities--are relatively unattractive at this juncture. Why is that?
Merk: Well, first of all, TIPS are dependent on CPI. Now, even if you don't think the government manipulates CPI, as you approach retirement your consumption basket is going to be tilted toward things like health care. So, we need to do a little bit more than beat that. In addition to that, when we had the latest round of discussions about the debt ceiling, both Democrats and Republicans were tempted to change the definition of the CPI just to do that to erode the purchasing power, and so we don't think you get enough bang for the buck with TIPS. There are bunch of other alternatives in there. They all have their advantages and disadvantages. Our specialty is currencies. We think investors may want to consider doing the same thing as the Chinese Central Bank does--mitigate the risk of any one currency by spreading your eggs to a basket of currencies.
Benz: Let's talk about how that would work. So what if inflation is in fact a global phenomenon and the U.S. dollar declines in value, but so do other major foreign currencies? How does a currency portfolio help mitigate that risk?
Merk: Some people say, "Hey, gold is the only currency--if you call it a currency--man standing at the end." And that may well be the case, except gold is very volatile. If you look closely and we spend a lot of effort studying central banks around the world. Actually not all things are equal. The Federal Reserve, the Bank of England, and these days the Swiss National Bank, they are the champs in the world of printing money. But some are far more restrained; think Australia, for example. But even the Europeans, as much as everybody hates the euro, the reason why we have these issues in the eurozone is because we haven't printed all this money. People here have to take care of their problems. It doesn't work very well, but the euro is as strong as it is because they haven't printed quite as much money. Now there is no safe asset, there is no perfect currency, but that is why we are advocating a managed basket of currencies to mitigate the risk of any one currency. Think about it differently. Bernanke has his toolbox. Well as an investor you may want to have your toolbox, and we think currencies play an important role in that.
Benz: Right now when you look across your portfolios and you think about the currencies that have the best chances of not being debased over time, what currencies are at the top of that list?
Merk: As I indicated, there is no perfect place. Last year, people told us, "Oh, put your money in Switzerland; that's the only great place to be." And you see what happened with the [Swiss government] intervention. Similarly, Australia is often cited. Well, the thing is when everybody loves a currency, everybody knows that it's the one good place, well, that currency is also pricey. Well, think of north the loonie, the Canadian dollar. Well, we all think everything is better in Canada, but at the same time the Bank of Canada always does something to weaken the loonie just again. And so that is why you want to spread to a basket of currencies, preferably a managed basket of currencies, and the reason I say managed basket is because you may not like our policymakers but they are predictable. We know where President Obama is heading toward. We know where Mitt Romney might be heading toward. We know where [German chancellor Angela] Merkel or the Greek leaders are going to head toward.
And so it's not a straight line. It's not just, "Hey, put your money into one currency and everything is going to be fine." Throw out that risk-free component in your asset allocation. Dollar cash is no longer safe, and I'm not just referring to the threat that your money market fund might hold some toxic assets from a European bank, but the purchasing power is at risk.
Now it's at risk everywhere, but at that cash end you want to spread your eggs. In our view you can add value with a managed basket, so that you don't get caught off-guard when something happens in Europe, Japan, and Australia. But it isn't easy. You have to take a proactive approach, but you don't have to do it in a high-risk environment. Currencies aren't all that volatile, if you don't use leverage. The euro moving one cent on a percentage basis is very little. So, you have a much lower risk profile than say with commodities or gold and it's just one of the tools that investors may want to consider.
Benz: Well, Axel, thank you so much for sharing your perspective today. We appreciate you being here.
Merk: My pleasure.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.