The dilemma of quantitative easing is clear from the correlated rally in all “risk” assets, and the corresponding rapid decline in the value of the U.S. dollar.
Global financial markets increasingly seem to think that we got the best of both worlds for risk assets. If the U.S. economynormalizes and grows again above par, equities and risk assets will rally. If the U.S. economy falters, then equities will also rally as the market increasingly believes it will be saved by the next round of QE2.
Quantitative easing (QE) describes a monetary policy used by central banks to increase the supply of money by increasing the excess reserves of the banking system. This policy is usually invoked when the normal methods to control the money supply have failed, i.e the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero. A central bank implements QE by first crediting its own account with money it creates ex nihilo ("out of nothing").
It is this creating money out of nothing that is potentially the problem. While the U.S. needs low rates, the emerging markets are experiencing a QE-ed boom and potential bubble.
Western countries led by the United States are growing below par and emerging markets are growing above par further leading to more global imbalances and potential asset market bubbles in the future.
America and other developed economies are to suffer from sluggish growth and potentially stagflation in the coming year because of budget cuts. Emerging markets and in particular frontier markets are expected to continue to boom.
Liquidity is focusing on scarce and expensive “growth” within global equity markets. The most expensive equities are seeing the greatest upward pressure on price. Too much money is chasing too few investable emerging market stocks. Barometers are Turkey, Indonesia, the Philippines and frontier markets like Sri Lanka and Mongolia.
The World Bank recently lowered its outlook for growth next year in China and across East Asia, urging officials in the region to curb inflation by raising interest rates and ward off asset bubbles to avoid a repeat of the Asian financial crisis.
As recently as July the Fed was talking of exit strategies, with the market then looking towards upside surprises. Now, the consensus is that quantitative easing will be needed, with much attention on QE2 being unveiled by the Fed in early November.
The comments of a former Fed member, speaking at the IMF/World Bank meeting in Washington, summed up present thinking, "Monetary policy is the only game in town”
The only stimulus will come from the Fed. Fiscal policy is completely paralysed by U.S. partisan politics. Indeed, there is still the possibility of tax hikes from January.
Given the politics, unemployment is figuring prominently in discussion about the U.S. Bernanke mentioned unemployment as a key early point in all his speeches. It would not be a surprise if the Fed engaged in QE3 over the next year but there are a lot of sceptics who question whether QE actually works!
Clearly it does, as unconventional monetary policy has allowed normality to return to most markets. But therein lies the challenge, which still concerned most policy markets in Washington as well as most central bankers around the world, namely that whilst additional QE might not provide much direct further boost, stopping it might be detrimental.
There is real risk that current conditions could lead to a repeat of the commodity price-driven phony inflation scare world markets last experienced in 2007 and early 2008. Any repeat of such a market dislocation will likely lead to an overshoot in commodity pricesdriven by financial investors in commodity indices and resource stocks, and ultimately resulting in a violent sell-off. That sell-off will again could likely be characterised by a violent rally in the US dollaras the carry trades are liquidated.
There is a growing risk that the FX market has over-shot to the downside and risk/reward ratios would suggest to book partial profit on US dollar short positions. There is a risk that recent sentiment regarding the certainty and magnitude of future QE2 may have stretched to extremes. For example some Fed officials statements may be an attempt to dampen market expectations that the Fed will announce a mega QE2.
Instead, the Fed may increasingly favor a more gradual and measured approach. This could set up the stock market for disappointment. With currencies war talk intensifying, the Fed announcing a mega QE2 would not be in the interest of most politicians let alone central bankers.
In the medium term, it hence seems that upside to U.S. stock is limited after the +12% surge in the S&P500 over the last few weeks.
Over a 12 month view however we remain “over-weight” equities as risk aversion recedes and investors turn to the economic prospects for 2011 supported by ample liquidity.
_________________________
Michael Preiss serves as chief equities strategist at Standard Chartered Bank, and appears regularly on CNBC Asia Pacific.