Morningstar Advisor - April/May 2010 - 38

Spotlight

High Inflation
How it could happen: Low interest rates coupled with the trillions of dollars that governments around the world have pumped into the global financial system get the inflation ball rolling. Banks renew lending, leading to more economic activity, and a healthy recovery ensues. Consumers, with their pent-up demand for new goods and services, return to their free-spending ways. A weak dollar makes imports more expensive. Demand from a burgeoning middle class in emerging markets further sends prices soaring. What investors can do: Buy TIPS, of course,

become more frugal and pay down their mortgages or shed their big houses. Savings rates climb, and businesses have a hard time increasing profits, which will damp employment and wages, keep GNP growth low, and create a long-term bear market.
What investors can do: Shed debt; consider

What investors can do: Buy floating-rate bonds and companies with float (firms that get money up front for services rendered later), such as Automatic Data Processing ADP, Paychex PAYX, International Gaming Technology IGT, and insurance firms. Unconventional approach: If real rates

long-term Treasuries (SPDR Barclays Capital Long Term Credit Bond LWC), zerocoupon Treasuries (PIMCO 251 Year Zero Coupon U.S. Treasury Index ZROZ), municipal bonds, and cash.
Unconventional approach: Look for wide-moat consumer-staples companies with mostly commodity inputs (which tend to have prices adjust quickly in the case of deflation) and low labor input (wages tend to be the slowest to adjust downward in the case of deflation). Firms with this cost structure that sell necessities and inexpensive goods will be less affected by consumer thrift and will keep pricing power. Also, consider brokerdealers with substantial bond trading operations, such as Goldman Sachs GS. They would make huge sums on trading spreads as interest in bonds drastically rises because of their higher real returns. Also, the government would be likely to continue fiscal stimulus, which would increase bond issuance and further boost profits for those firms.

rise without inflation, average into fixedincome holdings. Keep an eye on credit spreads, which might push out as debt becomes pricier and more difficult for corporations to cover. This could produce an excellent opportunity in long-term corporate debt as rates start to fall again in the future.

A Weak, Less-Dominant Dollar
How it could happen: Foreign governments,

such as iShares Barclays TIPS Bond TIP. Also, buy companies that dig things out of the ground to sell and buy commodities, not just gold, but agriculture and basic materials. Try iShares S&P Global Materials MXI. Levered companies with pricing power will also excel, as will raw real estate and real-estate plays, such as St. Joe JOE and Weyerhaeuser WY. The best investments of all might be those with extremely short-duration assets and long-duration liabilities. A good example might be apartment REITs with substantial long-term debt: As high inflation and rising mortgage rates push people to trade down in housing, rents rise each year with inflation to keep strong real cash flows, and the real value of the company’s debt drops substantially.
Unconventional approach: Borrow at

concerned about U.S. fiscal responsibility and economy, lose faith in the dollar and seek more-stable currencies. The U.S. government, in an effort to help exports, pursues policies to keep the dollar weak.
What investors can do: Buy foreign stocks (the less exposure to U.S. market the better) and domestic companies that export or have large overseas exposure. Consider foreign bonds (via funds such as Loomis Sayles Global Bond LSGLX, Templeton Global Bond TPINX, and Oppenheimer International Bond OIBAX) as a way to get exposure to foreign currencies. Precious metals and commodities are obvious choices. Unconventional approach: Diversify currency on some cash and short-term fixed-income holdings using foreign-denominated bank accounts (using a provider such as EverBank) or ETFs (PowerShares DB US Dollar Index Bearish UDN). An options strategy would be to buy calls on oil in the hope that a weakening dollar contributes to increased oil prices in a world that is still economically active but less dependent upon the United States to drive growth.

long-term fixed rates and invest proceeds in companies that dig things out of the ground.

High Interest Rates
How it could happen: China and others stop

Deflation
How it could happen: There is a new era of frugality—a societal shift from spending freely using leverage to saving and paying off debt. Retiring baby boomers, especially,

buying U.S. debt, forcing Treasury to raise rates to increase demand, causing rates to increase throughout the economy. The recovering economy fuels inflation, and the Fed responds by raising short-term rates to tighten credit.

38 Morningstar Advisor April/May 2010

Morningstar Advisor - April/May 2010

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