Incorporating the theme of reflation into your portfolio may be beneficial. Key positive effects of reflation are likely to be seen in precious metals, commodities, commodity-sensitive stocks, Emerging Markets, real estate, and Treasuries. The dollar and the Financial sector may be negatively impacted.

Precious metals: Gold may be the most obvious beneficiary of the Fed's intentions. Inflation and a falling dollar tend to lift gold investment demand as a way to preserve value. Gold prices made new all time highs last week. This trend can continue as the dollar falls and inflation picks up.
Commodities: Commodity prices-including, cotton, copper, and corn, just to name a few-may also benefit from the outlook for reflation and dollar depreciation. Industrial and agricultural commodities posted gains on the week. The potency of the reflation theme as it related to commodities can be seen in crude oil. Crude prices were up on the week despite the report of near record-breaking U.S. inventories.
Commodity-Sensitive Stocks: The Fed's intention to avoid a return to recession and the potential for another liquidity-fueled rally like that of 2009 argue in favor of stock market performance. On the other hand, investment banks may benefit from the additional credit to fuel profitable merger and acquisition deals and more bond underwriting as businesses look to refinance at lower rates. Nevertheless, since the Fed announcement, Financials have been the worst performing sector - the only sector to suffer losses.

Longer-Term Impact

While the near-term impacts of Operation Reflation are reasonably clear, the longer-term effects are not. Unlike during the financial crisis when liquidity was scarce, the benefits of adding more cash into the financial system on growth and employment may be very limited in the current environment given the already high cash balances at banks and corporations. In addition, U.S. stimulus cash may wind up fueling Emerging Market growth as U.S. companies deploy the cheap cash to fuel growth in markets with lower labor costs and stronger demand. The Fed also risks undermining the lower interest rates that are essential to growth by devaluing the dollar making U.S. Treasury bonds less attractive to the foreign investors that we are increasingly dependent upon to fund our national debt.

We are cautious on the longer-term economic growth impact of another round of stimulus. However, we do not believe a return to recession is the most likely outcome and believe that the economy will muddle through with below-average growth in the coming quarters. In the near-term, Operation Reflation provides us with an investment theme. And finally, though we expect near-term weakness in the stock market, the timing of the mid-term elections on November 2 and the Fed's next meeting on November 3 could help to fuel a year-end rally for stocks.
This week is light on data until Friday when the closely-watched ISM index, a barometer of the manufacturing sector of the U.S. economy, is released. But it is not until the following week that the market-moving U.S. monthly job report is released and start of the third quarter earnings season gets underway. The absence of much new news this week that would refute the pending Fed action leaves the reflation theme that was established last week to continue to unfold.


Jeffrey Kleintop, CFA, is chief market strategist for LPL Financial.


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