Inflation, Default, and Volatility Are Currently the Greatest Risks to Investors' Portfolios
If the US dollar continues to lose its world's reserve currency status, higher inflation should ensue.
With quantitative easing (QE), the Federal Reserve used an ocean of dollar bills to paper over credit risk, effectively replacing default risk with inflation risk. Part of the reason interest rates increased when the Fed enacted QE was that inflation expectations increased. Now that QE is being wound down, investors are repricing credit risk, but commodity prices are holding up rather well. In other words, it appears that the Fed was successful in bringing the economy back to a sustainable level, provided interest rates remain in this range.
Wages and GDP have disappointed, but the strength in commodity prices shows that the new reality is that corporations must deal with cost-push inflation in a constrained consumer environment, not the demand-pull inflation that many are looking for. From a fundamental standpoint, the sectors that have rallied are those with the most pricing power (utilities, energy, and materials), while those without pricing power have come under pressure.
From a portfolio standpoint, I have been deploying a new strategy in which I'm long selective equity names and a basket of international ETFs (70% of my allocation), while I'm opportunistically hedging those positions with commodities, Treasuries, and TIPS (28% of my allocation provides default and inflation protection) and Volatility S&P 500 (INDEXCBOE:VIX) options (1% to 2% of my trading positions, which increase in value amid uncertainty). I'll write more about this in the coming weeks, but it comes down to focusing on what I know: specific equities, diversifying with international exposure, and then hedging those equity positions with inflation, default, and volatility insurance, which protect against the greatest risks to portfolios in the current environment.
Dismantling the Dollar
As violence breaks out in Ukraine, you may notice that to this point, the major powers have engaged using economic weapons rather than traditional weapons. It appears that there's an effort to dismantle the dollar as the world's reserve currency. I've pointed out before [subscription required] that this happens over a generation, not overnight, but what it means is inflation.
I would point out that while China has its problems, the ultimate resolution means that the Chinese consumer will rise in prominence as consumer spending garners a larger portion of Chinese GDP -- especially if the Chinese yuan continues to strengthen and give greater purchasing power to the Chinese consumer. Consumer-oriented investments in China should outperform the industrial supply and commodity segments. These are the things to look for when measuring a reserve currency's status:
• The Fed losing control of the interest rate curve (a flatter curve at low levels and tight spreads indicates the Fed is in the driver's seat).
• An auction failure (not an issue).
• A weakening of longstanding relationships between the US and its allies. A reserve currency is a political currency, so watch Europe's reaction to the evolving Ukraine turmoil closely.
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