Quantitative Easing: Cruising the QE2?

When the voyage is choppy, better choose your lifebelt carefully

By Paul Mann, December 13, 2010

On November 3, the US Federal Reserve announced its intention to purchase a further $600 billion of longer-term Treasury securities by the end of June 2011 in a second round of quantitative easing (QE2). QE is what central banks do when they can't cut short-term interest rates any further. With QE2, the Fed is trying to cut the cost of longer-term borrowing by buying government bonds. Why? Because the US economy is still fragile, with high unemployment. If borrowing costs fall, the idea is that companies will borrow more to invest and consumers will borrow more to spend. This should create more jobs.

It's not clear what impact QE has had on the "real" economy. But it's definitely affected the price of equities, bonds and commodities. By driving down yields on the "safest" assets, the Fed has pushed investors to speculate in more risky assets. This looks set to continue. Isn't this a fine monetary policy to implement? What's wrong with cheap debt? One concern is that it can mean weaker, less efficient, more deeply indebted companies survive more easily. Good companies are penalised, as they look less attractive compared to riskier stocks and they have missed opportunities to pick up failing companies they would normally have acquired at attractive prices.

The Fed has set its course and is very unlikely to withdraw QE2. For me, an interesting QE2-related investment strategy revolves around Asia. Emerging markets are hardly cheap. But they could become a lot more expensive and their economies are at least heading in the right direction. I continue to gradually increase my exposure to emerging market assets and currencies (equities, bonds, mutual funds and ETFs) with a bias to Asia.

Global markets have reacted positively to QE2 and the injection of official liquidity should provide further support to equity markets. There are some signs of stability in the US. So, in the short term, we should be happy just cruising the QE2, or rather, buying those markets we see as the main beneficiaries. Longer term, the global recovery will return to centre stage in determining the trajectory of markets. While we should remain optimistic, we must still recognise that the impact of QE2 is uncertain. The combination of a weak dollar, strong emerging markets demand and tight supply is bullish for commodities notwithstanding the recent run-up in prices. But we need to be mindful of the resurgent unease in the Eurozone. Ireland has taken some focus away from EU members such as Greece and Portugal, while Spain has attracted some confidence. Policy-makers are also preoccupied by the spectre of inflation and the rhetoric surrounding currency devaluation. We have already enjoyed a remarkable September and October. While November is more volatile, I look forward to a stronger run-up to the festive season. I remain in a buying rather than selling pattern - "cruising the QE2" mode, but not anticipating only plain sailing. Attention to market movements, spikes in volatility and a disciplined approach to risk are essential.

Paul Mann is head of UK private banking at Bank Hapoalim, 020 7973 5444. paul.mann@bhimail.co.uk

Last updated: 12:16pm, December 13 2010