Amid the current chaos in the financial markets, I experienced a rare moment of clarity the other night. The MoneyWeek team was waiting with bated breath – along with the rest of the investment world – to see what Ben Bernanke would unleash from his printing press. When the news of the extra $600bn being pumped into the economy came through, we raced for the Bloomberg terminal to check the price of the dollar, gold, stocks – anything to get an idea of the market reaction.
And it hit me. This is madness. Around the world, financiers, investment bankers, investors of all sorts, all of whom would proudly call themselves free-market capitalists, were hanging on the decision of one small group of central bankers. And the buying and selling decisions they make now will be based to a very great extent on their bets as to what the eventual impact of quantitative easing mark II (QE2) will be.
As many MoneyWeek writers have pointed out in the past, and as Dylan Grice at Société Générale reminded us this week: “Why is it that the central bankers who lecture the world on the efficiency of the market mechanism to set prices don’t trust that same mechanism to efficiently set the economy’s cost of capital?”
But that’s the world we live in and the investment conditions we have to cope with. But what does it mean for investors?
What will the impact be?
One clear impact of QE2 so far has been to drive up asset prices. Ever since the end of August, when Bernanke started threatening to launch QE2, stockmarkets have been on a tear. That’s understandable. Investors saw what happened the last time central banks started printing money – stocks bottomed out and embarked on a massive rally.
Indeed, Bernanke has indicated none too subtly that one of the key aims of QE2 is to prop up asset prices. In an opinion column in The Washington Post explaining QE2, he said: “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.” It’s rarely been made this explicit before, but this notion of the Wall Street ‘wealth effect’ has always been part of Bernanke’s strategy – and Alan Greenspan’s before him.
This is what was known as the ‘Greenspan put’ – the idea that you could bet on stock prices rising because the Fed would protect you against the market falling. Basically, Bernanke knows that he can’t force banks to lend, or consumers to borrow. So he’s trying to influence behaviour the one way he knows he can – by pushing up asset prices and hoping it makes consumers feel better about spending.
There’s just one problem with this reliance on the ‘wealth effect’. QE isn’t just pushing up the price of stocks. It’s also driving up commodity prices. Players in the commodities markets like to make out that financial demand has little impact on commodity prices for ‘real’ end consumers. That’s because the idea that a bunch of bankers and fund managers are making it more expensive for everyone to heat their homes, drive their cars, and eat, is clearly unpalatable and raises all sorts of ethical and regulatory questions.
But unpalatable or not, since the Fed first hinted at further QE, the price of oil, for example, has risen from around $75 a barrel to more like $87 now, even though inventories of oil in the US are historically high, and oil cartel Opec has plenty of spare production capacity. And a decent chunk of that move has come about since the $600bn announcement was made last week.
To be fair, much of this can be blamed on the dollar weakening, rather than on ‘speculation’. For example, Opec has indicated that it will now be targeting a higher crude price, to compensate for the weaker dollar – Saudi Arabia’s oil minister Ali Al-Naimi has suggested a range from $70 to $90 a barrel.
But regardless of the precise cause, as Antoine Haiff, head of energy research at brokerage Newedge USA tells Bloomberg: “The past few years have shown that the more liquidity in the system, the more cheap money in the system, the more money flows into commodities, in particular energy.”
Investment banks JP Morgan and Bank of America (BoA) Merrill Lynch reckon that oil will be back above $100 a barrel next year. “The key risk for the Fed,” says Francisco Blanch at BoA Merrill Lynch, is that “energy prices will get out of hand.” The Fed might say it’s not happy with the current level of US inflation. But higher raw-material prices actually rob consumers of disposable income – hardly a way to make them spend more money.
As Charles Dumas of Lombard Street Research points out: “Food prices are 14% of the Consumer Price Index and energy 8.5%.” Even if only a small proportion of the recent rise in the price of food commodities is passed on to consumers, the combined impact of higher food and fuel costs could add around 0.75 percentage points to the consumer price index. It may not sound like much, but “with real disposable incomes unlikely to be gaining more than 2%” in the year to June 2011, this will seriously crimp consumer spending.
Dumas argues that this latest batch of QE is comparable to the Fed slashing rates in late 2007, which also resulted in a surge in food and oil prices, which in turn hit consumer demand. “Monetary growth soared, but the vicious recession was kick-started on a global scale by soaring commodity prices.” Dumas argues that, in the end, QE2 could in fact damage US GDP growth, rather than boost it.
Currency vigilantes and ‘QT’
The impact on commodity markets is bad enough. But the market that is suffering the most disruption – and could cause a lot more pain globally – is the currency market. As Richard Woolnough at M&G Investments points out, normally the threat of inflation would be bad news for bonds.
Now, deflationists would argue that the bond market is merely correctly pricing in a deflationary future. But Woolnough has a more convincing – and straightforward – explanation for current record-low bond yields: the ‘bond vigilantes’ who would normally force up yields have been chased out of the market by the Fed. It makes sense – if a price-insensitive buyer with potentially infinite capacity enters a market, prices are hardly going to fall.
“If the bond vigilantes are dead, who will take their place to enforce discipline?” asks Woolnough. The answer? The “currency vigilantes”. If central banks “are actually or are merely threatening to print money, then economic agents should act vigilantly and avoid this new money by exchanging it for other currencies or assets. It’s the rational thing to do.” In other words, instead of dumping bonds, investors worried about inflation will dump dollars.
Unsurprisingly, other countries aren’t too pleased about the prospect of the US deliberately forcing the dollar lower. The much-bandied-about threat of “currency wars” sounds pretty melodramatic. But when you’ve got both China and Germany nakedly condemning the Fed’s actions, it doesn’t sound quite such an exaggeration. The German finance minister, Wolfgang Schaeuble, described the Fed’s move as “clueless”, while China warned that the US owed emerging markets “some explanation”.
Of course, America is hardly alone in manipulating its currency. The countries who are objecting are the ones who benefit from a stronger dollar. You can argue that no one is forcing China, or any other emerging-market economy, to peg its currency to the dollar. However, the problem is that all this freshly minted money is seeking a home. And right now, one of the most attractive places is emerging-market economies, with their rapid growth and healthy balance sheets.
But as money floods into these countries, it drives inflation higher. One solution is to raise interest rates – but that runs the risk of attracting even more hot money, making financial conditions easier even although monetary policy has been tightened. So they have to defend themselves using cruder methods. That will quite possibly involve the wholesale reintroduction of capital controls, whereby restrictions are placed on the amount of money that can flow in and out of individual countries. Stephen King at HSBC has a nice name for it – quantitative tightening (QT). By restricting the influence of the rest of the world on the domestic economy, policy-makers can focus on using interest rates to control inflation, without having to worry about the impact on the exchange rate.
Brazil, for example, has already imposed taxes on inflows – bumping up the tax on bond investments to 6% last month. Thailand and Indonesia have also introduced measures to control government bond purchases. As King says: “Capital controls today are designed more to curb speculative activity, rather than stop inflows altogether or explicitly curb foreign controls of local productive assets.” We can expect to see a lot more of this, because as soon as one country imposes capital controls, the hot money starts to flow to other regimes, which then puts pressure on them to impose controls too. The danger, as Nobel prize winner Joseph Stiglitz puts it in The Guardian, is that this leads to “an increasingly fragmented global financial market, with almost inevitable spillovers into protectionism”.
What’s the end game?
Perhaps the biggest problem with QE is that it simply represents more of the same thing that got us into this mess in the first place. By printing money on request, the Fed is preventing America from getting to grips with its structural problems. From encouraging moral hazard in first the stockmarkets (the tech bubble), then the property market (the housing bubble), the Fed is now giving the government all the excuse it needs to neglect the challenges facing the country, by fuelling a bubble in government bonds.
Sure, China needs to rebalance its economy away from manufacturing and towards consumption. But America needs a similar rebalancing, away from consumption. As Stephen Roach of Morgan Stanley puts it, America’s problems include an “overly large financial sector, excess consumption, low savings rate, hollowed-out manufacturing sector, declining relative education scores, increasingly unequal income distribution” and “crumbling infrastructure”. It’s quite a list, and QE does nothing to deal with any aspect of it.
Bill Gross of Pimco, the world’s largest bond fund manager, is pretty upfront about what QE really means. In short, it’s “somewhat of a Ponzi scheme”. As Gross spells out, public debt “has always had a Ponzi-like characteristic”. Countries – particularly highly credit-worthy countries such as the US – assume that they can always ‘roll over’ existing loans. The theory is that they will ‘grow’ their way out of their debts, “allowing future prosperity to continually pay for today’s finance”.
But with future growth no longer looking certain, “it seems that the Fed has taken Charles Ponzi one step further”. The Fed is now “telling markets not to worry about [the US’s] fiscal deficits, it will be the buyer of first and perhaps last resort. There is no need – as with Charles Ponzi – to find an increasing amount of future gullibles. They will just write the cheque themselves.”
Yet even this Ponzi scheme can’t go on forever. As financial analyst Andy Xie puts it in China International Business magazine: “The world is heading towards high inflation and political instability. It’s only a matter of time before there is another global crisis. The first sign would be a collapsing Treasury market.” The “only reason to stay in [Treasuries] is that the Fed won’t let the market fall. But the underlying value is evaporating with rising money supply and the inflationary consequences. When all investors realise this, they will run for the exits and the Fed won’t be able to stop the stampede.” He reckons the next crisis will hit in 2012.
Of course, others are less pessimistic. Most mainstream pundits believe the Fed has no choice – given that its job is to encourage employment as well as price stability – but to try to “do something”. However, few believe it will work. An exception is Paul Kasriel of Northern Trust. Kasriel, who has a good track record, points out that a form of QE worked to boost GDP growth in America during the 1930s.
Between 1933 and 1934, the US raised the dollar price of gold from $20.67 per ounce to $35. At a stroke, this “increased the Treasury’s spendable funds by the increase in the value of its gold holdings”. This extra money – created “out of thin air” – could be used to repay the government’s bills without raising taxes or issuing new bonds. In other words, the Treasury pumped new money into the economy, just as the Fed is doing now.
And, says Kasriel, it worked. Economic growth picked up, along with money-supply growth. “If the QE of the mid-1930s worked to stimulate nominal GDP, why wouldn’t the recently announced QE by the Fed work similarly, assuming the Fed puts enough zeroes into the programme?”
He may be right. But any sign of recovery then leads to the question – what happens when rates have to rise and the Fed has to start unwinding its Treasury holdings? In short, our view is that one way or another, QE is going to result in inflation – be that accompanied by a stagnant or an inflating economy. We look at the best ways to play either outcome below.
The best ways to play QE2
So how should you invest for QE2 (and possibly QE3 and QE4)? It should go without saying that we’d avoid government bonds. They’re too expensive and at some point, the forces propping them up will disappear. On stocks, we’d stick with the high-yielding, quality blue chips we’re currently fond of. Yes, it’s not very exciting. But investment’s not meant to be exciting. You should be able to make a decision, then put your portfolio to one side, rather than having to sit glued to your screen, panicking about every little tick up or down in the market.
We’ve written about the sort of stocks we favour regularly in our daily Money Morning email and in previous issues of the magazine – broadly speaking, we’re talking about big pharma, tobacco stocks, utilities – the sorts of things you’ll find in Neil Woodford’s Edinburgh Investment Trust (LSE: EDIN), for example. If you are looking for more QE-orientated plays, then an interesting bet might be the shipping sector.
As for currencies, clearly gold is still a buy. As Merryn Somerset Webb notes, the president of the World Bank has suggested that gold may have a role to play in a future global monetary system. That suggests its bull market has a way to run. But if you’re looking at which paper currency to be holding your wealth in (or you fancy your hand at spread betting the currency markets), the surprising news, perhaps, is that sterling suddenly looks like one of the most attractive majors again.
Think about it. Britain may have a coalition government, but compared to other currency majors – Japan, Europe and America – our political situation is the model of stability. Japan goes through prime ministers so rapidly that hardly anyone raises an eyebrow when another one is slung out. Europe is increasingly divided between Germany and the rest of the eurozone. And after the mid-term elections, the US is gridlocked.
We also have a broad agreement that the government should be reforming welfare and trying to cut the budget deficit. Again, that puts us ahead of Japan, Europe (where the periphery countries are on the verge of collapse again), and the US. American citizens may be worried about the deficit, but as Keith Wade at Schroders notes, “where is the incentive for a politician to increase taxes or cut spending when more than half (and possibly all) of the budget deficit will be funded by printing money”?
What about another bout of QE in the UK? All things being equal, it would be bad for the pound. But all else isn’t equal. Japan and the US are also engaged in QE. The European Central Bank is keeping monetary policy tight, but the danger is that this will result in such political tensions that the eurozone will splinter. The euro could survive a break-up in a different form (perhaps as the reincarnation of the deutschemark) but between now and that point, the single currency is likely to see fresh weakness. Even if the UK economy weakens, inflation remains persistently and visibly high, which will make QE a harder sell. In the ‘ugly’ contest of global currency markets, the pound is looks relatively attractive for once.
• This article was originally published in MoneyWeek magazine issue number 512 on 12 November 2010, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.