Well, I’m back from vacation, five days of golf in the wilds of Sea Pines Resort on Hilton Head Island. Okay, I wasn’t exactly roughing it unless you count the number of my golf shots that veered out of the fairway but it isn’t Miami. It was an opportunity to renew old friendships, develop some new ones and a much needed rest for your market correspondent. I didn’t completely ignore the markets while I was gone though and the cool Carolina evenings provided me with ample opportunity to ponder the future and what it might hold for investors. Unfortunately, all that pondering led me to the conclusion that the most important market factor right now is one that I am loathe to address in a public forum – politics. Long time readers know that I am an equal opportunity politician basher, have little regard for either party and do my best to avoid politics in these weekly letters. But with an election a mere two weeks away, the time has come to ponder the consequences of our democratic actions.

Just prior to my sojourn into the hell that Pete Dye hath wrought out on Hilton Head, I subjected myself to the political theater of the second Presidential debate. To get this off to a balanced start, let me just say that unimpressed doesn’t even begin to describe my feelings about these two candidates. Despite Obama’s four year tutorial in stupid Keynesian tricks and Romney’s alleged business acumen neither of them has a clue how an economy actually works. The one-upmanship in China bashing was a particularly appalling display of economic ignorance. Romney threatened tariffs against the Chinese “when they don’t play by the rules” and Obama celebrated his actual Sino tariffs. Romney apparently believes that China seeking a cheaper currency is breaking the rules while the US doing the same is righteous and he carefully avoided the fact that the Yuan has risen considerably over the last decade with no discernible positive effect on the US economy. Obama trumpeted the “1000 jobs” saved  by his tire tariffs but like so many when it comes to economics, didn’t mention the unseen effect. I must have skipped the section of Wealth of Nations where Adam Smith talked about the positive aspects of reduced competition and higher prices.

Another area where economic illiteracy was on full display was during the portion of the debate devoted to energy. In a frightening display of agreement, both candidates claimed to have policies that would produce the ever elusive and meaningless energy independence. While Romney may be the more sincere in wanting to drill for oil and gas on every available plot of land or sea, public or private, Obama gave no quarter in professing his love for coal miners and oil drillers who might be inclined to pull the lever for another four years. Neither seemed to realize that their China bashing, which is nothing more than a thinly disguised call for a weaker dollar, and their desire for lower gas prices are mutually exclusive. To answer the man’s question who started the energy portion of the debate, no, it is not the job of the Energy Secretary to lower gas prices. The single largest factor in the rise of all commodity prices over the last decade is the weak dollar and to remedy that you need a President, a Treasury Secretary and a Fed Chairman who understand that. In the current administration that amounts to none of the above and in a Romney Presidency the top of the ticket is just as clueless.

So, what does all this economic cluelessness have to do with our investments? Only everything. For all  you Obama supporters out there, take a deep breath because I’m about to say something that will cause you considerable distress – Mitt Romney is likely to win this election. Before you start firing up the email programs and accusing me of being a Republican shill, be aware that I do not intend to vote for Mr. Romney or Mr. Obama. I cannot in good conscience do so when I believe neither of them represents my interests or beliefs. But based on the prevailing economic environment, all the evidence points to a Romney inauguration in January. There simply isn’t enough time for the economic statistics to improve sufficiently before the election and history says that voters are not kind to Presidents who preside over weak economies – or weak dollars for that matter (Bush being an obvious exception).

Assuming a Romney presidency is likely, we need to start thinking about the investment implications. The first thing that should be said is that the economic policies that emerge in a Romney administration are highly unlikely to exactly mirror the policies he and Ryan are trumpeting on the campaign hustings. The make up of Congress is unlikely to allow them to just implement the policies they claim to favor. (That is just as true of a second Obama administration by the way so all you hand wringers fearing the socialist revolution should just calm down.) However, at least one thing Romney has spoken of is highly likely to happen early in his administration – Ben Bernanke will go back to poisoning young minds at a University to be named later. And that my friends, has some far reaching implications that we simply cannot afford to ignore.

A Romney/Ryan administration will not look kindly on a continuation of quantitative easing and Bernanke’s replacement will reflect those views (my guess by the way is John Taylor). Bernanke may have pledged QE to infinity and low rates forever but he can’t bind his successor to that policy and it is unlikely to continue. The Romney administration will see the end of QE as essential to getting Congress to address our fiscal problems. Despite Romney’s rhetoric on China, the one effect I feel comfortable in predicting if this comes to pass is a stronger dollar. That has implications for the global economy and asset class returns across the board.

I founded this firm on a very basic principle about investing. Asset class returns are determined by only two factors – inflation and growth (a principle recently endorsed by none other than Ray Dalio at Bridgewater Associates). More specifically, when I consider inflation, I am most concerned not with the CPI or other government measures of inflation but with the value of the dollar as measured by a variety of market based indicators including gold, a broad basket of commodities, other real assets (such as real estate) and the dollar index. During times of a stable or strong dollar, capital will tend to flow to intellectual assets such as stocks. During times of a weak dollar, capital will tend to flow to real assets such as gold, commodities, real estate and collectibles. That simple observation is behind the construction of both our passive and active portfolios and it has served me well for many years.

That does not mean that if Romney is elected one should just dump gold and buy stocks willy nilly. A stronger dollar is definitely in our best interests long term but the short term effect may well be negative. Market participants have been conditioned over the last few years to see a stronger dollar as bad for “risk” assets and that won’t change just because the occupant of the Oval Office has changed. In addition, capturing the benefits of a stronger dollar will require better economic policies overall, not just a change in monetary policy. If the dollar rises simply because the Fed is restraining the supply, the result will most likely be a deflationary episode that will not be viewed favorably by financial markets. A stronger dollar needs to be a result of policies that increase the demand for the dollar for investment as happened during the first Reagan administration. That will make the coming debate over the fiscal changes that much more important. And it is another reason I expect the market to be perilous after the election regardless of who wins.

I am already starting to see some subtle changes in the markets in anticipation of a Romney victory. The dollar index has not fallen as many expected after the implementation of QE3 and still appears to be building a base for a move higher. Gold’s rally following the Fed’s announcement has largely been reversed. Oil prices have stalled and appear to be conforming with a pattern of lower highs that has prevailed since the peak in the summer of 2008. After a decade of a weak dollar the transition to a stronger currency will not be smooth. Investing in a strong dollar environment is something many investors have never experienced and they will have to learn new trading patterns. US multinational companies accustomed to the tailwind of a falling dollar will have to adjust. Countries that have benefitted from capital fleeing the weak dollar regime will have to adjust policy. Global capital flows will change and the effects will be felt from Shanghai to Brussels.

I may well be wrong about a Romney victory and therefore we are not making wholesale changes to our portfolios based on that expectation. What we are doing is trying to envision how a change in the political paradigm will affect our clients’ investments. The most obvious to us is a stronger dollar and all that entails. We are also, as we must, thinking about what might be required in the case of an Obama re-election. In the meantime, we are maintaining our diversification across all asset classes as we await the outcome. It is unfortunate that politics plays such a large role in determining what we must do as investors but it has always been thus and we are prepared either way. I’d suggest getting ready for some turbulence regardless of the outcome.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or  786-249-3773.

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