As the Northeast prepares for Hurricane Sandy, markets are preparing for their own perfect storm. The first feeder bands are coming ashore now and whether we feel the full brunt depends to a large degree on how the political class responds. The Fed is already in full FEMA mode with results similar to those witnessed after another Hurricane, Katrina. Ben Bernanke’s policies are intended to produce a “wealth effect” among those that already have some in the hopes that they will increase spending and eventually aid those who have none.

So far though, Bernanke’s trickle down policies have not worked and the only obvious effect has been to raise food and gas prices, a surge for which the middle and lower classes have no levees. Last week’s GDP report continued a string of quarters of sub-par economic growth that stretches back to 2010. Growth has averaged roughly 2% since then despite the addition of several layers of monetary deception known as QE 2, Operation Twist Parts 1 and 2 and QE 3. Each iteration has been less effective than the last and one can’t help but wonder if Bernanke secretly hopes for a Romney win and an early return to Princeton. As I’ve said many times over these last few years, monetary policy cannot fix our structural problems and trying to do so will just lead to bigger problems down the road.

Bernanke let the cat out of the bag concerning his policies recently when he scolded other countries monetary authorities for not allowing the US Dollar to devalue. In a speech at the Bank of Japan a couple of weeks ago, Bernanke suggested that countries on the receiving end of capital fleeing his policies stateside should just let their currencies rise. In other words, Bernanke wants and believes that a cheaper dollar is good for the global economy if all these ingrate countries would just let it happen. Asian countries, with a rising Yen and a few decades of stagnation in Japan as evidence, aren’t buying it. Neither are Brazil and other emerging market economies.

Bernanke’s now obvious desire for a cheaper dollar is a dangerous escalation in what has become known as the global currency war. Other central banks are actively seeking to offset the effects of capital inflows and ensure their currencies remain competitive. The resulting currency instability further complicates the difficult task of investment for global companies. Faced with currency volatility, the fiscal cliff and the uncertain outcome of the election, companies are sitting on their hands with the US and global economy suffering the consequences. The GDP report and the durable goods report, along with various regional manufacturing surveys, show a reluctance to invest. Non residential fixed investment fell in the most recent quarter while shipments and new orders of capital goods (ex-aircraft) are down 2.1% and 10% respectively year over year.

It is this lack of investment that is at the root of the US economic slowdown and while recovering residential investment may be a partial offset, we know that substituting house building for productive investment is not a long term answer. We’ve run that movie before and know how it ends. To be fair to Bernanke, his desire for a cheaper dollar is merely an admission that other policies that would make it more attractive to invest in the US are off the table due to political gridlock. Trying to devalue our way out of this mess is the long way around the mulberry bush and it is a zero sum game for the global economy. The only rationale for devaluation is to make US goods or labor less expensive relative to our foreign competitors. In other words it is about stealing some of the global economy’s existing production since our current policies are inimical to growth. That’s what a decade of bad policy has reduced us to and it is a sad commentary on the politicians who are responsible.

Bernanke’s policy of dollar weakness – inflation – is designed to induce spending as a cure for our economic ills when it is investment we need. The idea is that more spending will induce more investment to meet the increased demand. That may be true but a weak dollar almost ensures the investment will not be in the US. A falling dollar creates an additional hurdle for any investment denominated in US dollars. A company considering an investment in the US must consider not only the expected return of the project but also the expected depreciation of the dollar. Of course, the currency effect can be at least partially hedged but that also creates an extra expense that must be overcome for the investment to go forward. And hedging is a notoriously difficult task that has caused more than one company to come to ruin when done badly. Bernanke’s dollar policy may induce spending in the US but it won’t be sustainable without investment to expand our own future production. Attracting investment to the US will require a complete reversal of the weak dollar policies of the last decade.

The perfect storm of a failing monetary policy, flatlining corporate earnings growth, falling investment, the potential for a massive fiscal contraction and more political gridlock will not be easily weathered by the markets. Currency instability in particular is a whirlwind that could reap a nasty crop of protectionism and a further contraction of world trade. That won’t be in anyone’s best interests and the sooner the Fed is allowed to pursue more normal policies the better. Unfortunately, that can’t happen until we see better tax, spending and regulatory policies. No matter who wins the dubious prize of the Presidency I find it hard to be optimistic in the short term on that front. It may take another recession – but hopefully not a full blown crisis – before the politicians get the message. In the meantime, we continue to maintain a larger than normal cash reserve until the storm blows over.

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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