Outlook Update - "Hair of the Dog"

Interesting week with the elections and comments by the Fed. On the surface it would appear the outcomes ("pro" business Republicans taking the House and the Fed $600 billion QE2) are bullish for the equity markets.  

My take is that this week has pushed off the day of reckoning into at least the second half of 2011. The party in equities likely rages on into at least the first quarter, the dollar likely continues to slide, treasury yields are managed into an acceptable range, and we, as a country, take another pull of loosely crafted investment spending hooch that likely leaves one hell of a hangover when the sun comes up (or spurs the Fed into QE3, 4, 5...).

In all the headlines, I rarely see any politician, economist, or pundit put their finger on what I believe is the fundamental issue: An Accumulation of Years of Rotten Investment Decisions Fueled by Too Loose Monetary Policies. If we had taken our medicine in 2000, or any years since then, the issue would have been smaller. Instead, we keep prescribing ourselves a heavy dose of "hair of the dog" and hope to avoid any evil consequences.

Inflation Building from the Bottom-up
The anticipated wave of inflation appears to be rolling up through the supply levels in the economy, illustrated by the increasing talk about food companies raising prices to offset higher commodity prices. I believe it is very important for investors to identify companies with pricing power. Or, put in Porter terms, companies with clear competitive advantages, negotiating power with customers, and in segments that have not had excess investment spending in recent history. Industrial equipment, IT and basic materials like chemicals look attractive as businesses update their infrastructure and less competitive pressure allows them to pass along price increases. In addition, some basic food companies with strong brands likely perform well.

Weaker Dollar Raising Import Prices and Helping Exporters
As QE2 likely keeps bond prices where they are, and therefore yields relatively low, the U.S. dollar weakens. The weakening dollar, as should be expected, is helping to improve manufacturing activity and exporters.  The Institute for Supply Management's index of overall manufacturing activity rose to 56.9 in October from 54.4 in September. A number above 50 implies expansion. The largest increase in activity within the index was for new orders, followed by exports. The activity appears mixed between industries, with many saying commodity prices are hurting margins while others are more bullish, like this comment, "Our customer base — auto manufacturers — is expanding capacity and making major capital investments." (Fabricated Metal Products) This is where I want to play.

Once Again, the Outlook Clouds as Washington Reaches for the Levers.
In widely expected election results, the Republicans will take control of the House of Representatives in January. Rolling-back health care reform, avoiding tax increases, and tightening spending are likely priorities of the House starting in January. How the Democrats work with the Republicans for the remainder of the year, both from the current leaders in the House and the White House, will illustrate how 2011 likely plays out. Will it be gridlock? Probably not since the Republicans learned a lesson when they shutdown the government in the 1990's. Will the President make concessions in order to ensure important economic initiatives are tackled? I certainly hope so. From an investing standpoint, I believe this government will work harder to appease concerns within business. A government constantly tinkering with business rules can lead to uncertainty. A more sympathetic government should encourage business leaders to ratchet up investment decisions as their future tax and benefit cost structures clarify. My general view is that the results should help equity markets.

In terms of the Fed, it appears as if the Fed's actions are increasingly causing ripples outside of the country. An increasing number of foreign central banks are leaning towards tightening as the excess liquidity injected by the Fed sloshes into foreign markets, stoking inflation overseas. The combination of loose monetary policies in the U.S. and tightening overseas likely keeps downward pressure on the dollar for the foreseeable future. Even if the Fed slows its asset purchases, I believe the low discount rate likely continues to cause a sliding dollar, although this signal is a good time to re-evaluate the outlook for the dollar.

I expect the Fed to become much more fearful of inflation as we roll into 2011. Already there is a growing chorus of very well respected fund managers attacking the strategies of the Fed. Basically, the argument is that the Fed is causing long-term harm to the economy through its aggressive monetary actions. As I wrote in Liquidity Trap, the Fed is enabling diminishing returns in the economy by not holding business managers accountable for more and more marginal investment decisions. I agree with Gross and Grantham and have felt since 2000 that the Fed was just digging us in deeper. However, who am I? In the short-term I believe there is ample monetary stimulus to drive rising inflation due to the discount rate and declining reserves in banks.

So, does the Fed listen to these heavy weights in 2011, and prescribe a big dose of bitter medicine that could slow economic growth, or is it "Damn the torpedoes! Full speed ahead!"? In the thought-process of my sagflation theme - is deflation now more likely in the second half of 2011 after rising inflation through mid-2011? As we roll closer to 2011 we'll just have to see how drunk everyone is on the current stimulus.