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April 20, 2009

(Un)Intended Consequences: Uncertainty, Inflation and Inflexibility
by Axel Merk and Kieran Osborne

Present policies may be sowing the seeds for the next financial crisis. Despite recent market optimism, we believe present interventions could produce significant future adverse and unintended consequences. Rather than curing the patient, the present initiatives may be overprescribing the patient with medication that cause significant side effects (and leave a bad taste in the mouth).

Prior steps taken by policy makers and central banks seem to have by and large succeeded in stabilizing financial institutions and avoiding a disorderly collapse in markets around the globe. That said, we take great issue with the continued level of intervention in the markets and the "spend at any cost" mindset that appears to predominate Washington and the Federal Reserve (Fed). In our minds, much of the present policies and initiatives, while well intentioned, will have significant unintended consequences and only serve to cause further dilemmas down the road.

Bad Businesses Saved at the Expense of Good
Incentives are sorely needed that reward responsible, efficient businesses, not policies that restrict them. In our opinion, present policies are inefficient and likely to foster a deterioration of "good" business models, a situation that may, in itself, precipitate further government spending to get the private sector functioning properly again. Intuitively, if we know the government will intervene regardless when an economy enters a downturn or recession, one would think the government would like resources to be re-allocated from inefficient market participants to more efficient ones. Indeed, efficient markets ensure that in most economic downturns strong businesses tend to strengthen their industry position while weaker, less efficient players fall to the wayside. Yet there are many situations where we see the exact opposite currently taking place.

In Berkshire Hathaway Inc.'s annual letter to shareholders, Warren Buffet bemoans the implications of government intervention within Berkshire's competitive landscape. He notes that, perversely, those entities that receive government funding are at a distinct funding advantage over higher credit-rated businesses that did not. It appears we are now in a world where bad business models are rewarded with cheap government funding at the expense of those good businesses that never undertook the risky investment decisions their now-bailed-out counterparts did. By not relying on government funding, these "good" businesses now must raise capital in a risk-averse marketplace, where much of the liquidity has fled to "safe" government bonds and T-bills. As a consequence, these businesses are subject to much higher funding costs than those that receive government funding. To many, it is deplorable that bad business models should be saved at the expense of good businesses, but this is just one unintended consequence of present policies.

Uncertainty Breeds Heightened Risk Aversion
These unintended consequences create a heightened level of uncertainty in the marketplace that does not foster investment. Combined with a lack of clarity from the present Administration, it is no surprise that many investors seem to abstain: which industry is next to receive preferential treatment; which will suffer; who is next to be bailed out; which accounting standard is next to be reversed; what are the tax implications of such unprecedented spending?... the list goes on. Without clarity, investors become risk-averse, curtailing investment and reinforcing any downturn. Yet the lack of clarity provided by the Administration is pervasive. Just observe any of their recent news conferences - call us cynical, but all we seem to hear is "we're going to do this; we're going to do that" with no definitive explanation of what "this" or "that" actually is. More often than not, "this" or "that" is followed by rousing applause (almost appearing as if this were a queued applause track, or if some cryptic meaning were imbedded in the text that we're not aware of). A classic is the perpetual reiteration that "we'll go through the budget line-by-line". Despite the lack of substance one thing seems crystal clear: the government is going to spend, whatever the cost. The problem is that "whatever the cost" quite rightfully scares the hell out of many, ourselves included, because "the cost" may transpire to be much higher than anticipated.

Not only are the government's intended actions unclear, but many policies quite simply don't make sense to us. Take the relaxation of mark-to-market accounting rules. Many financial institutions have been criticized (and quite rightfully so) for the opaqueness of their balance sheets; the lack of transparency being a key factor in creating risk-aversion amongst investors. With low confidence in financial institutions prevalent throughout the marketplace, one would think it counterintuitive to allow these firms to lie about the true value of their holdings (perhaps lie is too strong a word - mislead, stretch the truth, "guess-timate"). Yet, ironically, the government now allows this opaqueness to proliferate through the relaxation of mark-to-market accounting rules.

Inflation and Inflexibility
Given that the Fed's printing press has been working overtime, there has been a lot of foreboding talk around pent up inflationary pressures recently. The threat of inflation is definitely front of mind for us, but more worrying is the idea that the Fed may actually want to induce inflation, and moreover, should inflation break out, the Fed may be incapable of reining it in, in-light of its present initiatives.

Many consider Fed Chairman Bernanke's speeches, publications and testimonies in Congress to be critical of the Fed's actions in being too hesitant to allow inflation during the Great Depression. Indeed, Bernanke and the Fed may wish for inflation today. Inflation bails out those with debt, and by any measure U.S. consumers are saddled with it. We have touched on this topic before (please see our prior newsletters "Bailout Economics - Politics of Self Destruction" and "Reflation Investing - Which Currencies Benefit"). Suffice to say, in our assessment, this would be a very dangerous route for the Fed to embark on. Should a rise in inflation happen to be greater than anticipated, we believe the Fed's present initiatives will severely hamstring its ability to mitigate it.

The Fed's announcement to purchase as much as $1.25 trillion dollars of agency mortgage-backed securities (MBS) not only creates significant latent inflationary pressure (to put the massive size of this program into context, the total size of the Fed's balance sheet before the crisis began was approximately $870 billion), but also inherently creates an unprecedented level of inflexibility at the Fed. Should the level of inflation exceed expectations, we are concerned that the very purchase of MBS assets may render the Fed incapacitated in addressing such a situation. As opposed to traditional Fed purchases (and most recent initiatives), MBS assets are relatively illiquid and much longer-term. Hence the Fed will find it very difficult to unwind the positions it is presently building, not to mention the fact it has pledged to hold them until maturity. As such, we have growing concerns that the Fed will have its hands tied should inflation break out - especially if the rapidity of accretion is extreme - it seems unlikely the Fed could significantly tighten monetary policy without causing yet another collapse in economic spending, while large-scale sales of these assets may drive yields up, hampering a recovery in the housing market.

Another consequence of the Fed buying Treasury Bonds and agency securities is that the prices of these securities, in our opinion, no longer reflect free market dynamics. As a result, rational buyers may consider these securities overvalued and reduce their appetite to buy them. If foreign buying is reduced as a result of the Fed's interference in the markets, it may have negative implications for the U.S. dollar. This threat does not only apply to foreign buyers. At a recent conference of institutional foreign exchange traders we attended, there was a discussion that U.S. based investors are increasingly seeking to protect against U.S. dollar currency risk. If U.S. investors progressively move assets abroad, that may obviously also have negative implications for the U.S. dollar.

We believe present actions create more questions than answers. While we don't have a crystal ball, all these initiatives make us rather concerned about the future state of the U.S. economy. Present policies may very well portend the next financial crisis...

In an upcoming analysis, we will expand on the discussion on what governments and individuals can do to seek more sustainable wealth. We believe any reform should focus on incentives: let the free market, not government credit facilities, decide where the money flows. We will also resume our discussion on how the U.S. dollar and other currencies may develop as the dynamics amongst policy makers around the globe play out. We already discussed what we call bailout economics; whether there are any hard currencies left; potential depression currency plays; as well as who may benefit as the world tries to reflate. To be informed as we continue these discussions, subscribe to our newsletter at www.merkfund.com/newsletter.

Portfolio manager Axel Merk, as well as former President of the St. Louis Federal Reserve and Merk Senior Economic Adviser William Poole will discuss the financial crisis on Wednesday, April, 22, 2009, at 4pm ET at Brown University in Providence, Rhode Island. Don't miss the event - click here for more information and to register. On May 11-14, Axel Merk will speak at the Las Vegas Money Show - click here for more information.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.

Axel Merk and Kieran Osborne
Merk Mutual Funds

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered the authority on currencies. His insight and expertise have allowed him to foresee major economic developments: As early as 2003, he pinpointed the macro trend of U.S. dollar volatility while warning about the building of the credit bubble. In 2005, Axel Merk positioned his clients to move out of real estate and protect them against a faltering U.S. dollar by investing in hard currencies and gold. In early 2007, he wisely cautioned that volatility would surge, causing a painful global credit contraction affecting all asset classes. He is a regular guest on CNBC, Fox Business, Bloomberg TV and frequently quoted in the Wall Street Journal, Financial Times, Barron's and other financial publications around the world.

Kieran Osborne is Senior Analyst and member of the portfolio management group at Merk Investments; he is an expert on macro trends and currencies and has significant international market experience. Prior to Merk Investments, Mr. Osborne was an equity analyst at Brook Asset Management, where he worked in both Australia and New Zealand. He has also worked in New York for MCM Associates, a U.S. hedge fund.

The Merk Asian Currency Fund invests in a basket of Asian currencies. Asian currencies the Fund may invest in include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund invests in a basket of hard currencies. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a hard or Asian currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds owns and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

The views in this article were those of Axel Merk as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice. Mr. Merk is the founder and president of Merk Investments LLC and is the portfolio manager for the Merk Hard and Asian Currency Funds. Foreside Fund Services, LLC, distributor.

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