Last Tuesday's midterm election brought change to Washington. Republicans gained 60 seats (as of now) in the House of Representatives, the biggest grab by either party since 1948. The GOP also made significant advances in the Senate, in governorships and state legislatures. The message from the voters is that Washington must focus primarily on the key economic issues: job creation, federal spending, the budget deficit and taxes.
It remains to be seen whether either political party is interested or able to work with the other. At the moment, gridlock seems likely. The challenge is complicated by the fact that there are now four distinct political camps. On the Democratic side, there are the liberals and moderates. The Republicans benefited in a big way from the Tea Party movement. But the latter is hardly in strong alliance with the former.
One particular area where we may see real progress is taxes. The probability has increased significantly that all or most of the tax hikes currently scheduled to occur in 2011 will at least be delayed.
The Fed, referring to a "disappointingly slow" economic recovery, said it will buy $600 billion of U.S. government bonds over the next eight months to drive down interest rates in a new attempt to encourage more borrowing and growth. With fiscal stimulus to help the economy unlikely to come from Congress and the president, the Fed is filling the vacuum with aggressive monetary policy.
In addition to the $75 billion a month in new purchases of Treasury debt, the Fed is expected to spend $35 billion monthly to replace mortgage bonds in its portfolio that are being retired. The Fed left open the possibility of doing even more if growth and inflation don't pick up.
There's considerable doubt whether this second round of quantitative easing (QE2) will prove successful. But it's an undeniable plus for your investments. After all, one of the reasons for QE2 is to further reduce the luster of risk aversion to the many investors who are flush with cash and Treasury securities, and boost the appeal of more risky assets that promise better returns in the form of higher income and capital appreciation.
By driving down government bond yields, the Fed wants to make borrowing even cheaper, and it hopes to encourage banks to lend more. In addition, higher financial-asset prices could encourage consumers to spend and businesses to invest. The printing of large quantities of dollars also pushes our currency even lower. This is a mixed blessing. But at least it makes U.S. exports cheaper and easier to sell overseas. And it boosts the value of your non-U.S. investments, as well as further increasing the attractiveness of gold, silver, oil and other commodities.
In fact, QE2 explicitly also reflects a desire of the Fed to eliminate the risk of Japanese-style deflation by increasing inflation. In the long run, this is not good for bonds. But it's better for stocks. And it's best for commodities as well as other "stuff", be it land, water, industrial products and so on.
Will the printing of all this money ultimately lead to much higher inflation? We think so, which is a yet another reason that "stuff" is all the more attractive. But it will take a while given the large amount of slack in the economy now.
With low interest rates and a weak dollar, a good chunk of the money that inevitably will flow into investment assets will go to emerging markets, where yields are higher, growth is stronger and budget deficits generally are much smaller. In addition to the emerging markets themselves, market-dominant companies that are positioned to benefit from global growth.
Meanwhile, this week the European Central Bank keep its benchmark interest rate unchanged, and the Bank of England decided against new stimulus measures. This is a plus for both currencies vs. the dollar.（From Dr. Stephen Leeb's E-mail）
