Its the bonds stupid.....

Amid the volatile equities markets, and all of the hoopla surrounding whether or not "this time is the real one", it is easy to forget the indicators that stare us right in the face. As Europe's demise has been the main focus of the market's attention, many of us (including hedge funds of late I'm told) have decided to stand on the sideline while allowing the others (and algorithms of course) to wage battle on each other. For those who are not hiding money under the mattress (which I'm convinced yields more than the 6 month CD I have), you might look at the macro picture, and see where equities fit in. A reasonable first question to ask is "do I think things are getting better?". "Yes" would seem to say that being long equities makes sense, and "no" or "I have no clue" would seem to suggest  staying away. But for now, the market is telling us the answer is no. All you have to do is look at the sovereign debt spreads in Europe. Through the recent rallies and occasional encouraging news, the bonds in these countries have seen waning demand. In my simple mind, I am willing to accept this as all the information I need to have for the time being that the economic situation in Europe is still incredibly dire.

So how is it that equities can perform in such an environment? Inflation, inflation, inflation. It is true that big Ben Bernanke has continued to say that inflation targets are met, and that prices are not spiraling out of control. There is room for debate about that, but it is rather clear that the policy options of intervening governments leave the door open for inflation. In the US rumors continue to swirl about a potential QE 3. Even if not, zero interest rates are unquestionably here to stay. In Europe, while the EFSF is not supposed to be taking ECB printed funds, Euros are still likely to be printed. And, today we learned that China is injecting 1 trillion RMB into its banks. More liquidity is stimulative and leads to inflation. While China has made moves to keep interest rates high to keep its hot economy in check, injecting liquidity into the banks can be nothing but inflationary. Bottom line, equities benefit from an inflationary environment as bonds suffer decreased real interest rates (the interest you receive in inflation adjusted terms).

Thus it is important to remember to keep an eye on the bond markets, and not assume that rallies in equities are indicative of confidence in the ability of struggling countries to combat their debt woes. If that were truly the belief, you'd see the bonds rally. Of course gold also benefits from inflation, but it is more likely than equities to get a "safety" bid, if panic sets in. As such, while playing the stock market from the long side is one way to take advantage of the likely inflationary environment to come, gold's added safety clause makes it even more attractive.