FRETTING OVER THE FALLOUT / BARRON´S MAGAZINE STREETWISE ( VERY HIGHLY RECOMMENDED READING )

Streetwise

SATURDAY, NOVEMBER 13, 2010

Fretting Over the Fallout

By KOPIN TAN

The market's dip last week is tied to worries over the side effects of the Fed's quantitative easing, amid fears China may raise interest rates.


EXTRAORDINARY MEASURES rarely produce merely ordinary consequences, so a week after the Federal Reserve promised to inject another $600 billion into our economy, the market was already watching for possible side effects from this strong medicine.


Friday's pullback in risky assets—including a 5.2% drubbing of Chinese stocks, their worst in 14 months, and a 3.3% drop in crude-oil prices—was blamed on the escalating likelihood that China must soon raise interest rates to fight inflation.


It isn't a far-fetched concern: All that money we're printing has to go somewhere, and faster-growing emerging markets—and the commodities they gobble up—offer some of the more obvious and compelling stories. That's why so many money managers traipsing through Barron's offices are pitching emerging-market investments and currencies (or at least U.S. companies with toeholds there), and Chinese stocks have jumped 22% since late August, while commodities have soared.


It's too early to start calling asset bubbles overseas (although Hong Kong, whose economy is hitched to China's but whose monetary policy is tied to the slumping U.S. dollar, looks like a prime possibility). But the clash between America's loose money and China's tightening tendency certainly bears watching.


Already, commodity prices have surged as the dollar weakened. Escalating spot prices may not vex U.S. consumers yet, since manufacturers absorb some of the rising raw-material costs, but commodities carry a bigger weight in the inflation barometers of many emerging markets. Some of these economies also link their currencies to the dollar, so when our central bank eases, they end up doing so too—unwittingly.


As a result, "either these countries tighten policy and slap on capital controls and taxes for foreigners, or asset prices and inflation carry on rising," notes Richard Cookson, Citi Private Bank's London-based global chief investment officer. That's why central banks from Brazil to India are raising rates, Brazil and Thailand are slapping on transaction taxes, and China last week introduced measures to cool the influx of hot money. Trying to stave off bubbles without choking off growth is a tricky balancing act, even for China, and that adds to the market's roster of concerns.


"To be bullish about emerging assets and currencies over the coming months, you have to believe the U.S. appetite for looser monetary policy is greater than China's appetite for tighter monetary policy," Cookson says. That's true for now. And that's why Friday's slippage puts only a slight dent in the rallies since late August of, say, 22% for the iShares MSCI Emerging Markets Index fund (EEM), 23% for crude oil and 17% for U.S. stocks. Consumer prices in China have risen just 4.4% over the past year, slightly higher than the 3% limit its government publicly tolerates. But if inflation gauges start pushing the 8% levels seen two years ago, or if rate-sensitive Chinese bank and property stocks start to swoon, watch out.


GOLD CLIMBED TO A FRESH record above $1400 a troy ounce last week, before slipping 2.7% Friday. Despite the threat of tightening money supply, it's hard to argue against the logic of holding onto some gold.


Much has already been made of gold as a hedge against depreciating paper currencies, and it's an ominous sign that ahead of this weekend's G-20 meeting, the U.S. has failed to extract a pledge from leaders to refrain from "competitive undervaluation" of currencies. But gold is a shield against other risks that could worry investors in 2011.


An all-out trade war is unlikely, but the U.S. has failed to prod China into revaluing the yuan, and is clashing with South Korea over cattle and cars. As growth slows across the globe and wages stagnate, politicians in developed nations are practising their protectionist rhetoric.


The recent jump in Irish bond yields is yet another reminder that Europe's debt problems are far from over. This time around, the European Union has a $750 billion back-stopping plan in place and a mechanism for buying government bonds. But the continent's wan growth and aging populations with mounting needs complicate the task of fiscal belt-tightening.


Gold should hold its value if paper currencies continue to slide, or if investors start fretting anew about everything from emerging-market bubbles to sovereign-debt defaults. Another risk, flagged by Michael Hartnett, Bank of America Merrill Lynch's chief global equity strategist, is that of U.S. municipal-debt defaults, since stagnant growth eats into tax revenues even as states' obligations continue to swell. If U.S. economic growth sputters, and credit-default-swap spreads of Illinois, California, Michigan, New Jersey or New York start to wobble, the government may be forced to step in.


Yes, yes, we know gold provides no yield, cannot be eaten or burnt for warmth, is hard to store and is even harder to wear (for anyone not in the NBA). The proliferation of gold ads on TV is also both annoying and worrisome. But it's too early to fade gold's rally, argues Jason Trennert of Strategas Research Partners.


Gold's 25% gain this year pales next to the 54% surge for silver, which has well-understood industrial applications beyond the purely decorative. Gold's rally also is very much a function of the buck's slide. As John Roque of WJB Capital points out, $1000 bought you nearly 50 ounces of gold in 1930 and less than an ounce today, but gold has no more surged than the dollar has slipped nearly 99% over that stretch.


Besides, at about 1.15, the ratio of gold to the Standard & Poor's 500 is still below the long-term average near 1.5 or levels pushing 3 in the 1970s. And as long as the U.S. feels entitled to spend beyond its means—and it says something that our schoolchildren ranked 25th among developed countries in math and 21st in science, but are No. 1 in confidence—"it's hard not to feel that the correlation between the West's sense of entitlement and the price of gold will only grow," Trennert says.

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