Ask Russ: Inflation, Treasuries, and International Dividends (IDV, DVYE)

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March 25, 2012 12:15pm NYSE:DVYE NYSE:IDV

Russ Koesterich:  One thing that has been fascinating about the last year is how often I get asked certain questions. A few topics stand out as the issues most investors are wrestling with: Inflation, emerging

markets, equity income, the puzzle that is the US Treasury market and gold.

Below, in the first of an ongoing series of posts dedicated to reader questions, I’ve compiled some questions posed by readers of my posts, along with my answers. If you have an investing-related question you’d like me to answer, please post it in the comments section below.

Q: Regarding my suggestion to look outside of the US for dividends: What about currency exposure when it comes to investing in international dividend stocks? Seeking Alpha Reader

A: Investors buying international dividend stocks will be taking on currency, as well as equity, risk. However, over the long term, this may not be a bad thing. The United   States still faces a number of structural issues – starting with the deficit – that will play out over the next decade. Because a weaker currency will help address some of those imbalances, dollar-based investors should consider increasing their allocation to assets denominated in other currencies (potential iShares Solutions: (NYSEARCA:IDV), (NYSEARCA:DVYE).

Q: Regarding my inflation outlook post: The logic that increases in the money supply lead to inflation is simple and has to be somewhat correct. However, explain Japan? They have “printed” incredible amounts of money for over 20 years and they have had deflation. Empirical data suggests rising population and wages push growth in the money supply and inflation, certainly not money supply all by itself. Seeking Alpha Reader

A: You’re right that money supply alone only explains a portion of the inflation picture. Wage growth, capacity constraints and overall demand also play a large part in driving inflation. In Japan, most of these factors have been deflationary, starting with weak aggregate demand. However, even in Japan, it’s useful to consider the monetarist argument. While Japan has anchored short-term rates at zero and increased its monetary base, the supply of money (M2) has been growing slowly due to weak bank lending. In Japan, M2 growth has averaged less than 3% year over year during the past decade. In contrast, in the United States, the money supply grew at nearly 10% over the past year. In short, Japan is a cautionary tale of what happens when the mechanism for credit creation – bank lending – breaks.

Q: Regarding my underweight view of Treasuries: I read that 91% of long-term Treasuries are being purchased by the Fed. Where does that money come from and how long can the Fed keep it up? What does this mean for the outlook for Treasuries? Seeking Alpha Reader

A: The Fed is purchasing a significant amount of long-dated Treasuries (the exact percentage depends on which timeframe you’re referencing). Effectively, this is the equivalent of printing money. The Fed buys the Treasuries and credits the Federal Reserve account of the bank it bought the Treasuries from. This has the impact of increasing the monetary base, which is currency + bank reserves. Basically, the Fed is creating money out of thin air. Now, while Fed lending impacts the monetary base, it doesn’t impact the money supply until banks use their new reserves to extend credit to customers. While the Fed can technically keep this up indefinitely, as bank lending rises, this policy runs the risk of stoking inflation. Given the dearth of private borrowers for Treasuries, cessation of the Fed program is likely to push interest rates higher. My estimate is that without Fed buying, the 10-year Treasury would probably be trading at a yield of around 3% to 3.5%, as opposed to 2%.

Q: Regarding my post on Obama’s Budget Proposal: Tax rates on dividends were higher during the 80s and 90s and if I recall the stock market did just fine. What are your thoughts on this in relation to your view that potential higher tax rates will especially hurt utility stocks? Seeking Alpha Reader

A: While a higher dividend tax rate wouldn’t hurt the underlying utilities business, it would lessen the value of a utility’s dividend stream. This is an important consideration for investors in utility stocks who often view this sector primarily as a dividend play. Utility stocks’ relative price-to-earnings ratio rose significantly following the Bush Tax Cuts as the after-tax value of the dividends went up. As a result, it’s reasonable to assume that the relative multiple for the sector would contract after a tax increase as a utility’s dividend stream would be worth less after taxes. Practically, this means that while the overall stock market multiple may not be impacted by a dividend tax increase, utility stocks are likely to revert to a lower multiple relative to other types of stocks.

Source: Bloomberg

Note: Some questions have been edited for readability.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. There is no guarantee that dividends will be paid.

Written By Russ Koesterich From The iShares Blog  The author is long IDV

Russ  Koesterich, CFA, is the iShares Global Chief Investment Strategist as well as the Global Head of Investment Strategy for BlackRock Scientific Active Equities. Russ initially joined the firm  (originally Barclays  Global Investors) in 2005 as a Senior Portfolio Manager in the US Market Neutral Group. Prior to joining BGI, Russ managed several  research groups focused on quantitative and top down  strategy. Russ began his career at Instinet in New York, where he occupied several  positions in research, including Director of Investment Strategy for  both US and European research. In addition, Russ served as  Chief North  American Strategist for State Street Bank in Boston.

Russ holds a JD from Boston College Law School, an MBA from Columbia Business School, and is a holder of the CFA designation. He is also a frequent contributor to the Wall Street Journal, New York Times, Associated Press, as well as CNBC and Bloomberg Television. In 2008,  Russ published “The ETF Strategist”(Portfolio Books) focusing on using exchange traded funds to manage risk and return within a portfolio.

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