Monetary Base, Deflation And Investment Strategy

Includes: EEM, GLD, JNJ, SPY, VDE
by: Disruptive Investor

The adjusted monetary base, which is an indicator of expansionary or restrictive policies, topped $3 trillion as of May 2013. The U.S. monetary base has grown by $2.2 trillion since the crisis started as policymakers expand the Fed's balance sheet in order to bail out banks and also to keep bond yields relatively suppressed through the bond purchase program. This article discusses the monetary base trend, the inflation trend and investment ideas considering the current scenario.

As the chart below shows, the adjusted monetary base has surged since 2008 and there has been a renewed surge in the monetary base in the last few months.

(Click to enlarge)

With the policymakers aggressively expanding the balance sheet, it is very likely that inflation concerns will be high. On the contrary, deflation concerns are high and the policymakers are still struggling to meet the FOMC target of 2% inflation.

The chart below gives the headline inflation and the core inflation in the United States. In the recent past, the headline and core inflation have dipped as concerns of renewed economic slowdown escalates. It is therefore not surprising to see the policymakers renew their efforts to trigger inflation through aggressive balance sheet expansion as indicated by the recent trend in the monetary base.

(Click to enlarge)

Unfortunately, the efforts have yielded little results so far. The reason is clear - while the policymakers try to flood the economic system with liquidity, the banking system is fine with hoarding cash instead of lending to households. This point is verified by the fact that the excess reserves of depository institutions with the Fed has ballooned to $1.8 trillion as of April 2013.

(Click to enlarge)

A clearer picture emerges on combining the two charts - Excess reserves of depository institutions with the Fed and the adjusted monetary base.

(Click to enlarge)

From the above charts and discussion, the following conclusion can be drawn -

  1. The Fed's expansionary policy becomes futile if the private banking system is not willing to take risks (as evident in the current economic environment)
  2. The headline inflation, which reflects the real economic activity, can remain depressed even if the Fed tried to further expand its asset purchase program
  3. The excess liquidity in the banking system can manifest itself in the form of inflation in different asset classes such as equities, commodities and precious metals
  4. The risky asset classes will remain highly volatile as money moves swiftly from one asset class to another. Also, the transition from a relatively undervalued asset class to an overvalued asset class will be quick in the current environment

The most important investment conclusion that follows from the above points is diversification across asset classes and geographies. I discussed in one of my earlier articles that a correction in equities is very likely over the next 3-6 months. As excess liquidity is currently flowing into equities, investors can remain on the sidelines and consider exposure on a very likely steep correction.

In terms of portfolio diversification, the following investments can be considered on any good correction during the remainder of 2013 -

SPDR S&P 500 ETF (NYSEARCA:SPY) - It has been proven that beating the index is not an easy task. Therefore, the strategy should be simple -- beat the index or invest in the index. From this perspective, SPY looks interesting. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.

SPDR Gold Shares (NYSEARCA:GLD) - The investment seeks to replicate the performance, net of expenses, of the price of gold bullion. After the current correction, gold does look attractive for long-term and can be considered as an integral part of a well diversified portfolio.

Vanguard Energy ETF (NYSEARCA:VDE) - The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the energy sector. With a low expense ratio of 0.19%, the ETF is a good investment option in a sector, which has good upside potential in the long term considering incremental demand from Asia and continued expansionary monetary policies.

iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) - The iShares ETF corresponds generally to the price and yield performance, before fees and expenses, of publicly traded securities in emerging markets, as represented by the MSCI Emerging Markets Index. It is important to diversity the portfolio to emerging markets as the EMs have the potential to significantly outperform developed markets in the long term.

Johnson & Johnson (NYSE:JNJ) - Among individual stocks, JNJ is a good investment option. I like this highly diversified healthcare company, with products as well as regional diversification. Further, the sector catered to by JNJ is not very prone to economic shocks. JNJ has been a good dividend payer in the past, with a dividend yield of 3.1%. In my opinion, the stock is excellent for a long-term portfolio. It also commands a higher rating than the U.S. sovereign rating.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.