QE2 and all who sail with her…
Neil Dwane, Chief Investment Officer Europe at RCM, a company of Allianz Global Investors, reflects on a turbulent and eventful week in the US:
“Whoever said ‘talk was cheap’ and ‘actions speak louder than words’ had clearly never met Ben Bernanke, Chairman of the US Federal Reserve (Fed), for he has succeeded, using only words at the central bankers get-together in Jackson Hole, USA, in August, to lift upwards all asset classes, with the single exception of the US Dollar (USD).
“Last week was the time for the action to start, and so far, Bernanke has managed to meet - but not necessarily greatly exceed - expectations. So what is the plan and what are the chances for success in our opinion?
QE 1
“QE 1 (quantitative easing) was part of the desperate attempts by many central bankers and politicians around the world to stop the financial sector bankrupting both itself and society at large. So far it has worked in my view, although the policymakers have probably failed to use the two year period of grace which resulted to make serious changes to the structure and activities of banks, or to resolve the global imbalances which were created over the last 20 years.
QE 2
“QE2 is a more US-centric effort aimed at lowering longer term interest costs through targeted purchases of US bonds, which is likely to promote US house refinancing and purchases, whilst simultaneously lowering corporate financing levels, so that investment and capital expenditure should increase. Additionally, we would expect investors to reject record low yields on bonds and move into higher risk assets including equities, which should cause them to rise. This in turn should boost the wealth of investors, so that with more investment and rising wealth, US consumers end up spending more, which should help to finally lift economic activity from the current sluggish rate.
“So far, so good, but surely of greater concern in the current ‘talk’, is the renewed focus on inflation and unemployment levels, since bonds are now supported by only one new big buyer in the shorter term. Investors should be warned that higher inflation, or more people returning to the employment market, while both good for the real world assets like equities, could be less beneficial for financial/monetary assets at the end of a 30 year bull run.
“The toughest question has to be, if USD 3 trillion achieved a result which for many is disappointing, to what extent can we expect an extra USD 900 billion to achieve significantly more?
The EU is broadly unimpressed with QE2
“Germany clearly disagrees in principle and the European Central Bank is actually trying to leave the detritus of QE1 behind, never mind introducing yet more stimulus at this point in time. The European Union has had a good summer in economic terms, and Germany has certainly had a positive effect, boosting broader economic activity across the region, in spite of the recent strength of the Euro. However, recent economic evidence in some of the PIGS countries (Portugal, Ireland, Greece, Spain) continues to show cause for concern, and the recent austerity updates from both Ireland and Greece show that further austerity may not be the solution, but default could be the alternative. So the outlook is mixed, but could improve if investor concern in Ireland, Greece, Spain and Portugal were to drive the Euro lower again.
Emerging markets
“Underlying economic activity in emerging markets remains, in our opinion, very robust and a clear decoupling with the US has so far occurred in economic terms. Nevertheless, many emerging market countries are exhibiting signs of strain at a local level. In China, it is the rapid appreciation in property; in Brazil, it is the rising consumer spending funded by bank credit, and in India, (as elsewhere), food inflation is on the increase and is causing great concern*. Emerging market countries are the clear recipients of global investment and money flows, exacerbated by the US Federal Reserve QE policies and, mindful of the 1997/8 collapses experienced in some Asian countries, they are all quickly acting to manage their foreign exchange appreciation through intervention, manipulation and now capital controls. This is, in my view, hugely ironic, since the more QE that is done, the more that the emerging markets need to interfere, all of which stalls the much needed fundamental global rebalancing act, whereby China consumes more and produces less, and the developed world consumes less and produces more.
“The other unnerving result of QE for emerging market countries, is that commodity prices of all types are booming, with cotton up 80% since July and soya up some 40%*. Some of the rise has been fuelled by US dollar weakness, the rest by growing demand and by interrupted supply, especially following poor weather recently. More food inflation is likely to exacerbate domestic issues in many countries, leading to both higher local wages and as a result higher product prices, which could well be imported into OECD** countries; these would purchase with weaker currencies which could start to challenge both central bank inflation-fighting credentials as well as corporate margins.
Markets
“At a corporate level, we expect that cash and access to credit may fuel mergers & acquisitions (M&A) activity. Equities in many parts of the world remain, in our opinion, attractive on a long term historical basis, have experienced only few investor inflows over recent months and years, (excluding emerging markets), and are very attractive set against these record low bond yields.”
“In our view, companies are clearly showing their delight at equity valuations by beginning to reinitiate the global M&A consolidation boom in industries from food, mining, technology and financials. They are also once again re-engineering their balance sheets to take on attractive low credit and retire equity instead. All of this is only possible because market rates for large strong companies are at levels seen only once in a generation and bond investors are hunting for any possible yield pick-up. With US dollar weakness continuing, we believe that commodities and related sectors are benefiting from both US hedging and the longer term secular growth of emerging market countries.”
“At RCM we believe that sentiment to equities is now at high levels and there may be more investor capitulation into equities in the coming weeks as equities globally are still very underweight in investors’ portfolios. We also believe, however, that the balance of risks has been changed fundamentally by this new QE2 policy, which we interpret as the Federal Reserve stating that it wants and needs inflation and a higher level of economic activity. In our opinion, this can probably only be achieved at the cost of a lower US dollar, a higher rate of employment and an increasing tendency to contribute to the great global demand deficit which already exists within emerging markets, against a scenario where bonds are priced for deleveraging, and de-globalisation and deflation may now be pointing in the wrong direction.”
“On this basis, should you fight the Fed sailing in this QE2 direction?”
* Source RCM
** Organisation for Economic Co-operation and Development
