Inflation or deflation?

Even the experts can't agree whether rising or falling prices lie in our future.

That leaves investors in a quandary: how to construct a portfolio at a time of great uncertainty. A wrong bet could be devastating. If your portfolio is built for deflation, for example, your assets will slump if the country instead experiences a bout of inflation.

The answer is to prepare for the economic scenario you think is most likely, and then build in some insurance in case you are wrong.

"If you want to win the war," says Rich Rosso, a financial consultant at Charles Schwab, "you have to own both sides of the fight to some degree."

Such an approach necessarily means some investments will suffer no matter how the economy turns. That is OK: Buying insurance doesn't mean you actually want to use it.

Here are three portfolios, each with built-in insurance. The first will do best in an inflationary period but won't be crushed if deflation instead rules the day. The second is for investors who fear deflation, but want some protection against potential inflation — even if it is down the road. And the third is aimed at investors who believe the economy will muddle through without severe inflation or deflation.

Inflation

If you believe all the government spending in response to the financial crisis will ultimately beget inflation, you want a portfolio that thrives in a period of surging prices.

Commodities are the primary play, because everything from oil and corn to copper and pork bellies should gain. Plus, commodities — particularly gold — hedge against the dollar, offering a 2-for-1 benefit if a weak dollar accompanies inflation, as some expect.

Since commodities contracts can be a hassle for individual investors, consider a fund such as Pimco's CommodityRealReturn Strategy Fund, which offers exposure to a broad swath of industrial and agricultural commodities.

Though it seems counterintuitive, cash can do pretty well, too. The Federal Reserve would likely fight rising inflation by pushing up short-term interest rates, allowing investors with cash to capture the escalating rates through short-term certificates of deposit and money-market accounts.

Michele Gambera, chief economist at Ibbotson Associates, says his research shows that in the last five bouts of meaningful inflation, returns on cash essentially matched the inflation rate, meaning it isn't losing its purchasing power. Online banks and local credit unions tend to offer the highest rates.

Treasury inflation-protected securities, or TIPS, are an obvious investment since their principal adjusts upward along with inflation. TIPS exposure is available through mutual funds, such as the Vanguard Inflation-Protected Securities Fund, though Steven Fox, director of forecasting at Russell Investments, notes that holding individual bonds to maturity is more effective as an inflation hedge since "the majority of the inflation protection comes when the inflated principal is repaid." Individual TIPS are available through brokerage firms or TreasuryDirect.gov.

Sharp inflation is generally a negative for stocks, because rising interest rates potentially pinch corporate profits and undermine economic growth. But a few stocks will likely do fine. Start with energy and metals stocks because higher prices for their commodities will boost earnings, says Mark Kiesel, a managing director at Pacific Investment Management Co., or Pimco. Include as well U.S. firms with pricing power, such as regulated utilities, domestic pipeline companies and manufacturers of specialty materials. Examples of companies to consider: miners such as Freeport-McMoRan Copper & Gold and energy giant Exxon Mobil, or companies indirectly tied to commodity prices, such as driller Diamond Offshore Drilling, farm-equipment company Deere and seed supplier Monsanto.

Insurance Component: Long-term Treasury bonds and municipal bonds.

Both will likely soar in value amid deflation because their long period of fixed payments would be an attractive source of income as prices for goods and services broadly fall, and as paychecks shrink. And Treasurys, in particular, would likely become a haven for foreign investors, further pushing up their price.

Deflation

 

Portfolio preparation is easier for deflationists: Put a chunk of money into long-term Treasury bonds and much of the rest into cash and some municipal bonds.

If broad-based deflation materializes, long-term Treasurys are likely to surge. The bonds' fixed-income stream, meanwhile, would be worth increasingly more relative to falling consumer prices.

Some investment-grade municipal bonds could serve a similar role while also providing tax advantages for high-income earners. But beware: Deflation would likely mean some taxing authorities struggle to service bonds reliant on a specific income stream, like user fees. Instead, stick to "investment-grade bonds tied to necessary services like water and sewage, power or necessary government offices like, say, a courthouse building," says Marilyn Cohen, president of bond-investment firm Envision Capital.

Round out your deflation portfolio with a big slug of cash. Though it won't generate much of a return in a low-rate, deflationary environment, cash in the bank will gain value as prices fall.

Insurance Component: Commodities react most drastically to surprise inflation, so they should be part of your insurance. Add in TIPS, too, and stocks geared "toward consumer-staple companies," says Ibbotson's Mr. Gambera. If inflation arises, companies such Coca-Cola, tobacco giant Altria, and toothpaste maker Colgate-Palmolive will have some pricing power.

Goldilocks Economy

 

Maybe, just maybe, world bankers will get this right, and the economy will experience neither severe inflation nor severe deflation.

"We think most likely the central banks of the world will get this close enough to right that we will settle in close" to a relatively benign inflation rate of between 1.5% and 2.5%, says Aaron Gurwitz, head of global investment strategy at Barclays Wealth.

In such a "Goldilocks" scenario — where the economy is neither too hot nor too cold — "risky assets would do best, so equities and bonds with some equity characteristics should receive the emphasis," says Scott Wolle, portfolio manager of the AIM Balanced-Risk Allocation Fund.

That means broad exposure to large-cap and small-cap U.S. stocks through funds such as the Vanguard 500 Index Fund or the Bridgeway Small-Cap Value fund; and exposure to developed and emerging markets through funds like the Vanguard Total International Stock Index Fund (mainly developed markets), and the T. Rowe Price Emerging Markets Stock Fund.

For the bond component, pick a fund such as the Fidelity Total Bond fund that largely owns high-grade, intermediate-term corporate bonds and mortgages, along with government and agency debt.

Insurance Component: Just in case the Goldilocks scenario is wrong, you will need insurance against either inflation or deflation. Pick up inflation protection through a commodity ETF, and deflation protection with long-term Treasurys. Cash also is OK in either situation.

Federal Reserve Chairman Ben Bernanke assured readers of this page (“The Fed’s Exit Strategy,” July 21) that he has the tools to prevent the huge reserves he’s pumped into the banks from generating an inflation that would abort an economic recovery.

But does the Fed have the guts to use those tools? Will it risk censure from Congress and the Obama administration if it tightens money at the crucial juncture when inflationary omens accompany a reviving economy? Mr. Bernanke signaled the probable choice by writing that “economic conditions are not likely to warrant tighter monetary policy for an extended period.”

The Fed’s past record of judging when and how to use its tools for regulating the money supply is not impressive, particularly in times of economic distress. Its financing of large federal deficits in the mid-1970s sent inflation up to an annual rate approaching 15% before Jimmy Carter repented in October 1979 and installed Paul Volcker at the Fed with orders to kill the monster.

More recently, the Fed’s continued easing of interest rates during the 2003 economic recovery created the credit bubble that collapsed last year with such devastation.

The Fed’s difficulties in getting money policy right stretch back to its creation in 1913. In 1930 it starved the banks, creating a string of failures that worsened the effects of the 1929 stock market crash. In 1937, it starved them again, contributing to a prolongation of the Depression that had been manufactured in Washington by the clumsy taxation and interventionist policies of Herbert Hoover and FDR.

To be sure, the Fed has had its good years. It financed the 20-year period of low-inflation growth and prosperity that began in 1983 when the Reagan tax cuts became fully effective.

But because of its often self-contradictory double mandate to promote both monetary stability and full employment—plus the rap it has taken from economists like Mr. Bernanke for stinginess in the 1930s—it often overreacts to recessions with excessive generosity. With its federal-funds interest rate target at near zero, the spigots are now wide open. And as Mr. Bernanke promises, they will likely remain that way for an “extended period.”

Quite apart from the question of the Fed’s will, there is another large issue. Mr. Bernanke’s assurances to the contrary, there can be doubts about whether his tools are really adequate to deal with the powerful inflationary pressures the politicians are in the midst of creating in the form of a mountainous and rising federal deficit.

Mr. Bernanke showed that he is well aware of that danger when, in his semiannual report to Congress on July 21, he pleaded with that body to bring the deficit under control. The federal budget deficit is projected at an incredible $1.8 trillion for the fiscal year ending Sept. 30, almost half of proposed federal spending. The Treasury’s financing needs will be even higher than that when you count in the various “investments” the government has made in auto, housing and other dubious ventures.

But the day after he issued that plea, President Barack Obama was pleading with the American people to support his nationalized health plan. This plan would yet add hundreds of billions more to the deficit.

The Fed has been financing a significant part of the government’s profligacy, and it is riding a runaway horse. Even if it has the means to cope with present financing needs, will it be able to do so when, and if, the economy actually recovers and it has to finance both a recovery and a spending-crazed government?

Martin Hutchinson, a former merchant banker who blogs as “Prudent Bear,” wrote in May that the German Weimar Republic was monetizing 50% of government expenditure when in brought on the ruinous hyperinflation that destroyed the mark in the early 1920s. The Fed in May 2009 had monetized 15% of federal expenditures over the preceding six months—well short of the rate that destroyed the German economy, but not negligible.

The Treasury (and Congress) has been depending on the Fed’s massive buying of Treasury bonds to keep the government’s financing costs within reasonable bounds—as weakening international demand puts downward pressure on bond prices and upward pressure on the interest rate the Treasury must pay. The yield on the 10-year Treasury bond is below where it was a few weeks ago but well above early this year when investors world-wide were seeking the safety of U.S. Treasurys. Even massive Fed support hasn’t been enough to prevent slippage in bond prices this year.

The Fed has more than doubled the size of its balance sheet in the last year to over $2 trillion. As of July 30, it held $695 billion in Treasurys, up $216 billion from a year earlier. In addition, it has added nearly half a trillion of mortgage-backed securities it purchased to keep Fannie Mae and Freddie Mac, now wards of the government, afloat.

Adjusted reserve balances of member banks exploded in late 2008, soaring to $950 billion from $100 billion in four months as the Fed has pumped liquidity into the banking system. They peaked at nearly $1 trillion in May. The reserves provide banks with a shield against runs but they also are high-octane fuel for bank lending, which means they can touch off another credit bubble, and the accompanying inflation, when credit demand picks up again.

In his Journal op-ed, Mr. Bernanke listed ways he can keep this monster in check. The Fed can pay interest on the bank reserves it holds. This would lessen the incentive of banks to find private borrowers and keep some reserves out of the credit stream, damping inflation potential. But the net effect would be to add still more liquidity to the system, which would run counter to the longer-term goal of mopping up liquidity.

He said that the Fed could also sell securities to the banks with an agreement to repurchase them, but these “reverse repos” would only mop up liquidity temporarily.

The standard way for the Fed to soak up liquidity, mentioned last on Mr. Bernanke’s list, is to sell Treasurys to the banks. That would draw down bank reserves and reduce their inflationary potential. Under the Basel I international banking rules, Treasurys are zero-risk investments and don’t have to be matched at 8% of their value with additional capital, as does private lending.

With the huge volume of Treasury financing coming down the road, the Fed will have plenty of bonds to sell (it already has, in fact). But the Fed buys Treasurys primarily by creating new money, or in other words by inflating the money supply. Will it have the nerve or even the capacity to “sterilize” inflation by reselling the bonds to soak up bank liquidity? Again, there are those political pressures. Will the Fed’s admittedly bright money managers be able to strike a balance between warding off inflation and leaving the banks with sufficient liquidity to finance an economic recovery?

As to that huge volume of mortgage-backed securities the Fed is now holding, what is to be done with them? They are “toxic,” which is why the Fed bought them as a means of keeping Fannie and Freddie solvent. They are “guaranteed” by Fannie and Freddie, which means they now are guaranteed by the U.S. Treasury. So they are yet another liability to add to all the other liabilities being piled on the Treasury. The Fed already has financed them once; will it have to finance them again when they come up for redemption?

In short, there are very good reasons to doubt that the Fed can cope with the political problems of avoiding inflation. The technical problems don’t look very easy either.

China's Gains in Manufacturing Stir Friction Across the Pacific

China is on its way to surpassing the U.S. as the world's largest manufacturer far sooner than expected. The question is, does that matter?

In terms of actual size, the answer is, no. But if size is a proxy for relative health of each nation's sector, the answer is yes.

Anyone who walks the aisles of a U.S. retailer might think China already is the world's largest manufacturer. But, in fact, the U.S. retains that distinction by a wide margin. In 2007, the latest year for which data are available, the U.S. accounted for 20% of global manufacturing; China was 12%.

The gap, though, is closing rapidly. According to IHS/Global Insight, an economic-forecasting firm in Lexington, Mass., China will produce more in terms of real value-added by 2015. Using value-added as a measure avoids the problem of double-counting by tallying the value created at each step of an extended production process.

As recently as two years ago, Global Insight's estimate was that China would surpass the U.S. as the world's top manufacturer by 2020. Last year, it pulled the date forward to 2016 or 2017.

"The recent deep recession in U.S. manufacturing does mean that China's catch-up is occurring a few years earlier than would have been the case if there had been no recession," says Nariman Behravesh, the group's chief economist.

U.S. manufacturing is shrinking, shedding jobs and, in the wake of this deep recession, producing and exporting far fewer goods, while China's factories keep expanding. If manufacturers on both sides of the Pacific were thriving, there would be little reason to butt heads. But given the massive trade gap between the two nations and uncertainty in the U.S. over when and to what degree manufacturing will recover, China's ascent has become a point of growing friction.

Chinese manufacturing activity continued to tick up in July from the previous month, data from the China Federation of Logistics and Purchasing showed Saturday. The Purchasing Managers Index edged up to 53.3 in July, from 53.2 in June and 53.1 in May.

Many economists argue that the shrinking of U.S. manufacturing — both in terms of jobs and share of gross domestic product — is a normal economic evolution that started long before China emerged as a manufacturing powerhouse. From their point of view, the shrinking would happen regardless and is actually a sign of health that the sector doesn't need to be big to be productive and is shedding low-skill jobs and creating select higher-skill ones.

Global Insight's Mr. Behravesh is one of those who views China's rise as normal, even healthy. "In the natural course, countries go from agriculture to manufacturing to services," he says. "To subsidize manufacturing pushes [the U.S.] backwards down that curve."

But another school of thought — one known by the somewhat backhanded label of "manufacturing fundamentalists" — contends the U.S. decline isn't natural and must be reversed to retain America's economic power. From their perspective, that necessitates fighting Chinese policies that fuel low-cost exports, swamping a variety of industries from textiles to tires.

"The notion that we can be a nonmanufacturing society is folly," says Peter Morici, an economist at the University of Maryland. "It's pseudo-science that gives rise to the collapse of civilizations."

The Obama administration is stepping carefully through this minefield. At a two-day conference last week, the first meeting of a new forum designed to foster closer cooperation between the two countries, China's tightly managed currency policy was barely discussed even though it is a hot-button issue for many U.S.-based producers and organized labor. They argue that China undervalues its currency to gain a competitive advantage for its exports, which sell at a lower price in the U.S.

The U.S. Business and Industry Council, which represents U.S.-based manufacturers, accused the Obama administration of "panda-hugging." The administration earlier this year softened its stance on the issue when it declined to label China a currency manipulator.

John Engler, president of the National Association of Manufacturers, says he doesn't expect China to surpass the U.S. before 2020. "It may or may not continue to grow so rapidly," he says. "The importance of the China challenge to the U.S. depends on how we respond to it," such as implementing tax and investment policies that encourage domestic producers to expand.

Mr. Engler's group faces a delicate issue of its own regarding China: Many of its powerful members produce in China and are eager to avoid controversy on trade issues, while the group's large roster of smaller members are often outspoken critics of China.

Even in its weakened state, manufacturing remains a surprisingly large part of the U.S. economy. The sector generates more than 13% of the nation's GDP, making it a bigger contributor to the economy than retail trade, finance or the health-care industry. In China, manufacturing represents 34% of GDP.

Still, the concern remains that U.S. manufacturers now being hit by the economic downturn will never recover. J.B. Brown, president of Bremen Castings Inc., a family-owned foundry in Bremen, Ind., says the downturn has halted what had been a hopeful trend that emerged last year of work returning to the U.S. from China.

"I see a lot of people starting to look at going overseas again," he says, in part because costs are rising in the U.S. even in the depth of this recession. He notes, for instance, that Bremen's electricity rates jumped 17% this year — and the company has been warned they could increase even more next year. Foundries like Bremen use large amounts of electricity to heat metal.