It’s been a dull year for the U.S. economy.

But don’t expect a repeat in 2011.

In fact, as we enter the New Year for the U.S. economy, investors face some major risks. Should the U.S. Federal Reserve opt to maintain its record-low-level of interest rates, it’s very likely that we’ll see the kind of virulent inflation that will send commodity prices skyward, and inflict some real long-term damage in the process.

With higher rates, the U.S. economy could experience its second downturn in three years, the kind of “double-dip” recession that would boost an already scary jobless rate – while also sending U.S. stocks into a bearish tailspin.

[ad#Google Adsense]With uncertainty the watchword for the New Year economy, U.S. investors need to position themselves to cash in should the currently anemic U.S. advance continue, while at the same time making sure to protect themselves against a potential downturn.

As contradictory as that might sound, it is possible to do both.

Unstable Backdrop

After a burst of growth late last year hinted at a full-blown recovery, 2010 has turned into a disappointment – with gross-domestic-product (GDP) growth creeping along at a wheezing 2.0% pace.

Inventory buildups – a situation that can’t continue – have artificially inflated growth figures. Final sales to end-consumers – probably a much better indicator of real U.S. growth – have advanced at just a bit more than 1.0%.

This uncertainty has investors and other crystal-ball gazers asking: What’s in store for the U.S. economy in the New Year? Will we see a vigorous recovery? Or are we headed for a “double-dip” recession – complete with higher unemployment rates and another bear market in U.S. stocks?

Most investors probably believe that 2011 will likely be a carbon copy of 2010 – just more of the same.

But I think that’s highly unlikely. The New Year is unlikely to resemble this one because the economic backdrop is uncertain and unstable.

Housing Woes

Record levels of fiscal and monetary stimulus are accompanied by low inflation and an anemic level of economic growth. If monetary stimulus at this level is continued through 2011, inflation will have to return with a vengeance.

Housing is also a problem. After the temporary surge caused by the homebuyer subsidies that ended in April, U.S. housing prices seem to be heading downward again.

That’s not a surprise: Housing prices in this country remain well above their long-term average in terms of family incomes, and the inventory surplus caused by the “bubble” hasn’t been resolved.

Indeed, I would estimate that the final bottom in the housing market is still maybe two years away. Prices still must decline by an average of 10% to 15% – with the biggest decline slated for the Washington, D.C. suburbs, where prices have been “artificially” propped up by the government expansion of 2007-2010.

This further decline will weaken bank balance sheets, creating trouble for the U.S. financial-services sector.

Fuel for a Double-Dip Recession

A real resurgence in inflation would – after a battle with U.S. Federal Reserve Chairman Ben S. Bernanke (who at this stage faces considerable opposition from the Fed) – lead to an increase in interest rates, and probably a substantial one, at that. That would undoubtedly lead to a recessionary relapse – one that’s accompanied by another banking crisis as the declining value of the bonds banks hold on their balance sheets would be exacerbated by additional housing-loan losses.

Technically, it would be quite difficult to officially imbue such a downturn as a “double-dip” recession – chiefly because it would begin around three years after the previous recession ended in June 2009 (it had its start in December 2007).

The two recessions of 1979-80 and 1981-82 are generally considered as separate economic events, even though both had the same underlying causes – the surge in oil prices and the Fed’s policy in tightening interest rates to extraordinary levels. In this case, if the second “dip” is brought on by Fed tightening, it isn’t likely to occur until after 2011.

Even if the Fed is harassed by the new Republican Congress into tightening substantially by the end of the year, the effect on the economy will take some time to kick in. While the commodities bubble may well burst during 2011, as global monetary policy is seen to be changing direction, the Fed is likely to delay major tightening until 2012, which would delay the second downturn until late that year – or even until 2013.

Every Cloud …

Despite the many concerns related to monetary policy, there is some good news on the fiscal side of the U.S. economic ledger.

While the new Republican Congress is likely to extend the Bush tax cuts, those are already built into the current economic position and so their extension will have little effect. However, if the new Congress cuts back on government spending – as it has promised, and as the Republican congresses of 1995-98 also did – there will be a stimulative effect on the U.S. economy. (It’s only fair to note here that the Republican congresses of 1999-2006 did not cut back on spending, meaning that this remains a risky assumption).

In country after country, it has been shown that increasing public spending tends to depress output, as resources are diverted into less-productive needs. That’s especially true when the government goes into a deficit-spending mode to do so, since its massive borrowing tends to “crowd out” private-sector borrowing.

For similar reasons, cutting spending is stimulative, since that frees up capital for the private sector, which tends to find uses for that capital that are more innovative.

You can see this effect in Germany, which has outperformed earlier forecasts even as it runs the rich world’s smallest budget deficits. In Britain, too, the government’s turn to austerity has been accompanied by a surge in output, with GDP growing at 3.2% per annum in the latest quarter – versus the inflated 2.0% advance here in the United States.

A “Bottom-Line” Outlook for the U.S. Economy

Clearly, if Congress cuts back on government spending in the New Year, we can expect to see some acceleration in growth. However, that acceleration will be brought to an end – probably in 2012 – by the surge in inflation from the U.S. central bank’s amazingly accommodative monetary policy, which will cause a rise in interest rates and a crash in commodity and U.S. Treasury bond prices.

This development – combined with the still-troubled U.S. housing market – will spawn a new (actually, a renewed) banking crisis. And that will make the next recession an exceptionally nasty one, with a market “bottom” and spike in unemployment that’s deeper and more damaging than the predecessor that ended in 2009.

[ad#Google Adsense]There could be a good-news outcome to this gloom, however – provided that the second “dip” is followed by restrained public spending, that bank bailouts are avoided and that interest rates are boosted to a level that’s at least 2% to 3% above the inflation rate. If those conditions are met, U.S. growth will resume at the traditional brisk U.S. rate, probably with a post-recessionary catch-up to absorb the high level of unemployed people and other resources that have stood idle.

That brings us to the bottom line for this New Year U.S. economy outlook: If, as I expect, Congress cuts public spending substantially, while the Fed pursues easy money as long as it can, my prognostication is for rather faster growth in 2011, followed by a nasty financial crisis and second “dip” in 2012-13. After that, if fiscal and monetary policies have been restored to a more normal track, the U.S. economic recovery that follows that nasty spell should be brisk as what we experienced in the very strong stretch that took place from 1983-85.

Actions to Take: With uncertainty serving as the watchword in the New Year, investors will want to position themselves to profit should the U.S. stock market run up – while at the same time protecting themselves against possible downturns.

Impossible, you say?

Not if you adopt our Money Morning “protective portfolio” to your own needs.

Here are the five steps that you can take. This strategy will allow you to add to your existing holdings in such a way that you will benefit should the economy (and U.S. stock market) continue to advance. But should the U.S. economy stumble, causing U.S. stocks to do the same, these moves should cushion – or even offset – some of your losses.

Investors looking to adopt such a stance should:

  1. Buy gold: At some point, the U.S. Federal Reserve will be forced to abandon what is clearly the most accommodative monetary policy in modern U.S. history. But until that happens, inflation remains a real threat. And that means you need to hold gold. There are many ways to invest in gold. Physical gold is always an option. Exchange-traded funds such as the SPDR Gold Trust (NYSE: GLD) is also worth considering.
  2. Buy dividend-yielding U.S. stocks: Income rules, especially during periods of uncertainty. Most investors fail to realize that dividends account for a major piece of the historic returns that stocks have offered over the long haul. Dividends provide a cushion during the tough times, when stocks are stuck in a trading range, and can help prop up a company’s share prices when the broader market is in decline. One good example right now is B&G Foods Inc. (NYSE: BGS), the Parsippany, N.J.-based maker of such consumer products as Cream of Wheat oatmeal, Maple Grove syrups and pancake mixes, Ortega taco mixes and sauces – as well as many other products that grace American cupboards. The stock currently yields 5.3%.
  3. Reap the best of both worlds: As part of the portion of your portfolio dedicated to U.S. stocks includes several American companies that have some muscle in overseas markets. This is a great way to hedge your bets – you get the disclosure and accounting-rule benefits of U.S.-listed companies, and the growth offered by such fast-evolving overseas markets as China, India, parts of Latin America and other parts of Asia. Companies in this category would include such U.S. stalwarts as Caterpillar Inc. (NYSE: CAT), McDonald’s Corp. (NYSE: MCD), soda-and-snack-maker PepsiCo Inc. (NYSE: PEP), soft-drink giant Coca-Cola Inc. (NYSE: KO), jet-airliner leader The Boeing Co. (NYSE: BA), and fast-food magnate Yum! Brands Inc. (NYSE: YUM).
  4. Look abroad: It’s a U.S.-centric world no longer. That means that markets such as China, India – and others – can no longer be viewed as portfolio afterthoughts. They must be given serious consideration at the start of the construction of any investment portfolio. In the New Year, one such market that can’t be ignored is Chile, which is positioned to be a top performer in 2011. The most-straightforward way to travel is the exchange-traded fund route, via the iShares MSCI Chile Investable Market Index Fund (NYSE: ECH). In terms of individual stocks, check out Vina Concha y Toro SA (NYSE ADR: VCO), a producer of very-high-quality wine. It’s currently trading at about 21 times earnings, with a dividend of nearly 4.0%. That’s a somewhat premium valuation, but I like the dividend and Vina Concha is unquestionably a premium company.
  5. Don’t ignore the possibility of an economic downturn: If the U.S. economy were to experience a “double-dip” recession, the U.S. stock market will suffer in kind. We recommend buying out-of-the money “put” options on the U.S. Standard & Poor’s 500 Index. Look at options that are well out of the money. That will allow you to purchase this “insurance” at a reasonable price, and will put you in a position to offset some of your losses with gains on these securities – should U.S. stocks nose-dive. You can purchase these on the Chicago Board Options Exchange (CBOE). Right now, I’m looking at the December 2012 puts with an S&P 500 strike price of 700 (meaning the S&P would have to fall from its current level at 1,186 all the way down to 700 – a 40% decline). This option right now trades at approximately $37. You’ll only make money if the market really crashes – as it did in 2008. But if that happens, you’ll reap a real bonanza.

— Martin Hutchinson

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* Source:  Money Morning