Uncertainty hitting investors from all sides

Investing has always been fraught with uncertainty, but rarely has the average investor been confronted with as much uncertainty as is the case now. Investors face uncertainty about the U.S. economic recovery and whether there will be a double-

dip recession; about whether the Federal Reserve will be able to head off the threat of deflation and the possibility that the economy could slide into a long period of Japan-like economic malaise; about the impact of financial and health care reform not only on banks and health insurers but on most other companies; and about the long-term impact of the federal, state and local government deficits.

Now they have three more uncertainties to confront.

The first is the very real possibility that the weak dollar resulting from the actions of the Treasury Department and the Fed will provoke inflation and even a currency war. The second is the possibility of a trade war with China, and the third is the foreclosure mess that has resulted from sloppy bank paperwork.

The release last Tuesday of the minutes of the most recent meeting of the Fed’s monetary-policy arm only heightened the concerns, as it showed the central bank leaning strongly toward further quantitative easing as a means of stimulating the economy.

Although further quantitative easing might spark the economy, there is a danger that it also could spark inflation in a year or two when the economy revives and too much money chases too few goods. A more immediate danger is that it could drive the dollar further down against other currencies (which would also contribute to inflation by making imports more expensive).

A cheaper dollar might help boost U.S. exports, but it could also provoke other countries to devalue their currencies to protect their exports to the United States. Some countries are already taking tentative steps.

Last month, Japan’s central bank sold some $20 billion in yen in the currency markets to prevent the yen’s rising too steeply against the dollar and harming Japan’s exports to the United States. Also last month, Australia’s central bank postponed an expected increase in interest rates, in part because it likely would have pushed the Australian dollar even higher against the U.S. dollar, making Australia’s exports uncompetitive.

IMPLICATIONS FOR CHINA

Because China ties its currency to the U.S. dollar, a weak U.S. dollar not only makes U.S. exports more competitive, it also makes China’s exports more competitive against those of other countries.

The second uncertainty arises from the weakness of the U.S. economy, and the fact that the Chinese currency is tied to the dollar at what most experts think is an exchange rate that is too low. This has prompted calls in Congress for retaliatory action against Chinese exports to the United States if the yuan isn’t soon allowed by the Chinese government to float to a more realistic exchange rate.

That could provoke a trade war between the United States and China that could quickly get out of control, and that prospect brings to mind the effect of the Smoot-Hawley trade barriers that contributed greatly to the seriousness of the Great Depression.

The third uncertainty is the foreclosure mess, which has brought the weak recovery in the housing industry to a screeching halt.

Most economists think that a recovery in the housing industry is a key ingredient to economic recovery. That has now been postponed for an unknowable period.

Given these new uncertainties, investors and their financial advisers can be forgiven for being conservative.