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Rising Inflation and Budget Cuts: Where to Invest Your Money Now

Stay with your stocks, is the message that investors are getting from some key market and economic forecasters. They're betting that the economy can stand up by itself, as the government cuts its budget and the stimulus programs gradually wind down.

Not that there isn't plenty to worry about: high gasoline prices, unfinished revolutions in the Middle East, Japan's nuclear meltdown, Europe's ongoing banking crisis, simmering global inflation, and unsustainable U.S. debt.

If you had been able to foresee these events, you'd have rushed out of stocks many months ago -- and you'd have been wrong. The market's animal spirits, greased by stimulus from the Federal Reserve, kept propelling prices higher -- up 25 percent since last September. Prices dipped in March, on the spike in oil prices, then rose again.

What the bulls see is rising numbers of jobs, stellar corporate profits, and inflation rising but not by enough to knock the expansion down. The U.S. currently looks like the strongest performer among the developed countries (Europe and Japan).

Market analyst Doug Ramsay, of the Leuthold Group, an institutional stock research service, thinks that stocks might be in a "bull market extension" -- climbing 15 to 20 percent into 2012. He bases his forecast on Leuthold's technical research into stock momentum.

Economist Lakshman Achuthan, a principal of the Economic Cycle Research Institute, sees "an accelerating phase of the business cycle, something that we predicted last November when many were still clinging to double-dip recession fears."

There's remarkably little worry about the impact on the total economy of slicing $38 billion out of federal spending authority. The budget passed by Congress this week hurts particular programs but is only a drop in the bucket of government spending -- not nearly enough to give the economy withdrawal pangs.

There could be a positive reaction at the end of June, when the Federal Reserve ends its own stimulus effort. During a deflation scare last year, the Fed decided to pour $600 billion in extra reserves into the biggest banks. The intent was to strengthen the economy, by making more money available for loans and lowering longer-term interest rates.

"On all counts it failed," says economist Lacy Hunt of Hoisington Management, an investment advisory firm. Suspicious investors sniffed more inflation ahead, and interest rates (including mortgage rates) went up instead of down. Wall Street traders borrowed the money to speculate, piling up record increases in margin debt. Commodity prices boomed. Households now face higher food costs as well as the higher gasoline costs driven by disruptions in the Middle East. Spending on items other than gasoline stalled. Many factors affect prices, Hunt says, but the Fed has been "aiding and abetting" the general increases.

When the Fed withdraws, Hunt expects these trends to reverse. Inflation expectations should ease, letting interest rates fall and easing the price pressures on commodities. Real incomes should improve. If these forecasters are right, your investment program should look like this:

1. Stay in your bond funds. If ending Federal stimulus moderates the pace of economic growth, inflation fears will ease and long-term interest rates will edge back down, Hunt says. He thinks that investors who are switching into short-term bonds are making a wrong-way bet.

Jim Floyd of Leuthold likes high-yield bond funds, even though they're not the bargains they were six months ago. A growing economy lowers their default risk.

2. Don't be afraid of municipal bonds. Their tax-equivalent yields are still close to their all-time high. In February, scare stories about potential defaults set off a tidal wave of selling. Investors have been taking money out of muni funds at the rate of roughly $500 million to $700 million a week, the Investment Company Institute reports. But the states are driving some tough budget cuts and tax revenues are going up, which reduces credit risk. "The problems are severe, the road is long, but the trends are favorable," wrote Robert Elsasser of the investment advisory firm CTC Consulting in a recent report to his investors.

3. Keep the faith in stocks, including foreign stocks. In a "minefield of risks," the economy has enough push behind it to keep profits and prices moving up, even if growth slows a bit, says Allen Sinai, chief global economist for Decision Economics. But over the long run, he sees international investors moving away from the dollar and the United States. "No sensible person looks at what's happening in Washington and thinks that's any way to run a country," he says. Of his top countries to invest in, seven are in Asia (led by China), plus Russia ("a rich country and the world's largest oil exporter"), Germany, Canada, and Australia. He is "underweighted" in the United States.

The hair in the soup might be oil prices. A temporary spike won't have much of an effect on the business expansion, Sinai says. But a permanent new high would stall the economy later this year and into 2012. "The U.S. has not faced up to the problem of negative oil shocks" and the need for energy independence, he says, -- another reason to invest elsewhere.

You might, however, take a flyer on nuclear energy-related stocks. Leuthold's David Kurzman thinks that nuclear power won't shrink, as an industry, despite the Daiichi meltdown. Nuclear remains one of the low-cost sources of electric power, he says, and some major countries (China, Russia, India) are adopting it. He sees good buys in the shares of nuclear service companies and uranium mines.

It's said that markets climb a wall of worry, and the wall today is high. Something unforeseen could turn these forecasts over in a moment. For now, however, that's where the consensus lies.

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