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By Paul Justice, CFA | 03-31-2010 05:24 PM

Hedging Inflation/Deflation Risk with Currencies

Merk Funds president Axel Merk on the euro, the Australian dollar, and the forces behind today's general price instability.

Paul Justice: Many investors are worried about inflation, deflation, or general price instability, as am I. I'm Paul Justice, associate director of ETF research at Morningstar. Today I have the pleasure of being joined by Axel Merk, the president of Merk Funds, and an authority on currencies. Thank you for joining me.

Axel Merk: Good to be with you.

Justice: You have some great perspectives as to how we've gotten to this state in the generalized markets, and why people are concerned about potentially an inflationary market or even deflationary.

Can you tell us about the government policies that may have gotten us to this point over the last decade, and your views on those?

Merk: Sure. Maybe first, I think both camps are right. We have a threat of inflation and a threat of deflation. If we allowed the market forces to play out after the housing bust, then we would have a deflationary downward spiral.

Having said that, the policymakers have decided that politically it's suicide to encourage homeowners to downsize, and as a result they're pushing very much for inflationary policies to push against the trend.

If we did not have a Federal Reserve very firmly committed to try to push against that trend, I would say the market forces play out. But given the composition of the Federal Reserve, given the effort at the administration to fight that trend, what is happening is that we're printing money, we're spending money, as much as we can, but because of the market forces, all of that if very inefficient, ineffective.

And what you see happening is, you see inflation where you have the monetary sensitivity. You see it in commodities, you see it in the Australian dollar, a currently highly correlated with commodity prices.

But you do not see it in corporate profits, and you see it very slowly making it to other areas of the economy.

Justice: These are incredible forces that are pulling against each other, and we have a political mix mixed into the entire equation, which makes it difficult for us to vet out what the economic factors are as individual investors.

How do you approach this challenge of dealing with the hedge for inflation or deflation, or possibly both? What do you do in uncertainty?

Merk: We try to keep it simple, and the way that we do it is we focus on currencies. By focusing on currencies, you can focus on the major macroeconomic trends without being drawn into the very specific that happen on the corporate level.

As I mentioned, the Australian dollar is a prime beneficiary of reflationary efforts. But there are also other places. For example in Europe, everybody loves to bash the Eurozone, but in fact, because Europe is structurally--in our view--less capable of printing and spending as much money as the U.S. is, the Eurozone may ultimately be an anchor of stability.

Now that may sound very controversial, but what happens when you don't spend as much money and when you don't print as much money, is you may end of with lousy economic growth on a backdrop of a strong currency.

And Bernanke has testified so in Congress that he believes that going off the gold standard in the Great Depression helped the U.S. economy to recover from the Great Depression. And he's absolutely right.

When you debase a currency, when you try to take purchasing power away from people, they may work harder and you may not want to be part of that. As a result, you may not want to move out of the U.S. dollar to invest in some of those currencies.

Justice: Would you say at this point right now you've got a more bullish stance on what the euro is going to do going forward, given what we've had over the last six months?

Merk: The euro has been on sale, and it's rare that the euro is on sale. When the Europeans rejected European constitution, the euro was on sale. Right now there has been a panic because of Greece. That provides a wonderful buying opportunity, we believe, because ultimately we believe Greece will be seen for what it is.

Greece is 2% of the Eurozone GDP, and that is a small portion. We do not believe in a contagion story. On the one hand, because the appropriate backstops are put in place. We do know how governments react in a crisis, that the European Central Bank would provide unlimited liquidity if there was a Greek default.

And we know that the respective governments would bail out their banks. And we know that Germany could single-handedly bail out Greece. So we know that the worst-case scenario is not the end of the world.

Other countries like Spain, in our view, are in a very different situation. Spain has one of the lowest debt levels of any Western country. They have an unemployment issue, they have a housing issue; they do not have a debt issue.

Justice: Greece is the headline today, there'll be another headline sometime tomorrow, and I'm sure our opinions would change at that point in time.

I appreciate you answering our questions.

Thank you for joining us. I'm Paul Justice with Morningstar, and thank you, Axel Merk.

Merk: My pleasure.

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