What will QE2 achieve? And is it necessary?

In a recent post this single line has attracted much unrest.

"We have QE2; not at all a reliable basis on which to base investment decisions."

Everyone seems to feel QE2 does form a good basis to invest. Here is why I do not believe it is a reliable basis to invest: It is priced. In fact QE2 was reasonably foreseeable even in July 2009 when I posted on US Policy Expectations. Once a course of action is so apparent, when it occurs, its short term impact is a reversal, even while the long term implications gain in stature as event risk reduces.

Developing nations are way over-leveraged; seigniorage (creating money by printing it) is an easy way to reduce the real value of debt. QE2 is simply printing money to buy back debt, thus flooding the market with liquidity and seeking to drive interest rates down to stimulate consumption and investment. Interest rates are already at historic lows; and driving them lower will not provide a solution on consumption and investment.

What will QE2 achieve? And is it necessary? In my view, the answer to both is yes. In the short term, QE2 means that the $ will weaken. Longer term, adoption of seigniorage by other leveraged developed nations will be necessary to maintain status quo in global export markets so the rate balance amongst developed economies will be relatively stable. With seigniorage, developed market currencies will be in surplus supply; with variable and rising money supply, currencies lose value and they lose status as a store of value. A flight to real assets (timber, basic materials, energy etc.) commences; this together with rising costs of imports (as a result of a weaker currency) from emerging economies stokes inflation in developed markets. And inflation ultimately lowers the real value of debt.

The natural policy response to rising inflation is higher interest rates. Raising interest rates in developed economies in the face of rising inflation will be plain stupid; the most important thing to return to health is to reduce the real value of debt. This can be done through not one but all of fiscal austerity, higher taxes and seigniorage coupled with inflation tolerance. In the present circumstances, the solution will likely lie in acceptance of a convergence of inflation rates in developed economies with higher levels of inflations in emerging economies. While the actions of the Federal reserve indicate that US seems to be arriving at a conclusion that tolerance of inflation at a higher rate will be necessary, the point seems to be missed by Europe.

Interest rates as a policy tool work in a capacity constrained society; as demand grows, from time to time, it has to be cooled to allow time for capacity creation, so that demand can be met from capacity, instead of prices rising irrationally as a result of capacity short falls. In developed economies, today there is no capacity constraint. Tolerating higher inflation without raising interest rates will help move global currencies closer to purchasing power parity; this will facilitate capacity creation in developed economies to fulfill demand from growth economies even while the domestic developed market resets to a more moderate level of demand even as deleveraging occurs. And as the real value of debt falls and deleveraging continues, exports grow, even as imports shrink, slowly the economy is restored to health.

The surplus money from developed markets also finds its way to traditionally capital deficient emerging growth markets. Demand for the currencies in emerging markets from capital account will cause emerging market currencies to strengthen. And initially, before capacity from new capital gets created, this flow of capital will drive asset prices and inflation in emerging economies higher. This inflation does require a policy response through rising interest rates (and possible controls over capital transfers which will keep asset price inflation contained even as interest rates address consumer prices); remember, capacity creation needs to be given time to catch up with demand. In addition, while developed economies must tolerate higher levels of inflation, emerging economies must attack inflation for effective convergence of global inflation. Strengthening of currencies in emerging markets weakens competitiveness in export markets; in some ways this makes sense as over-leveraged developed economies will demand less as they deleverage. At the same time, in the long term, leveraged developed economies gain competitiveness as demand from emerging economies rises. For emerging economies, the initial spurt to trigger "emergence" may well come through exports, but in the long term, any emerging economy must develop through its domestic market. The good news is that in the long term, emerging markets benefit from cheap growth capital. And while export markets get weaker, robust growth in domestic demand is beneficial. Finally, structurally high inflation is unlikely because as commodities get more expensive in $ terms, import bills drop as the local currency strengthens.

What does all this mean for investors:

1. Stay long emerging markets;
   
2. Stay long commodities (materials, energy, food, water, timber etc.);
   
3. Inflation means rising total return via dividend payouts and slower total return capital appreciation; focus on dividend income and you will gain capital appreciation once people recognize the shift;
   
4. Pick strong brands capable of protecting high margins in the face of rising input costs;
   
5. Pick companies with earnings stability, but bear in mind that stability should be viewed in the context of the economic sector in which the company operates. For example if you compared earnings stability of Coke versus BHP in a single year, you may buy Coke, but if you compare stability over an economic cycle, valuation may guide to in a different direction at the bottom of a cycle.
   
6. While a strong balance sheet is always welcome, don't over-rate it; the much touted "high-quality" focuses on a lack of debt together with high and stable returns as key elements of quality. This neglects to note that cash will depreciate in value even as the real value of debt falls. Do not fear leveraged companies which can sustain debt service and pay-down from existing income streams and use debt to grow; they will benefit with falling real value of debt as inflation rises.
   

Global markets can never be de-coupled. Trade is built on comparative costs; its built on competitive advantages; its built on capital flow dependency; its global entities operating in a global world. Always keep in mind the sheer size of developed economies. At a global level, a 1% slowdown in US real GDP will require over 14% growth in real India GDP for the impact to be neutral globally; call it the base effect; call it what you may; but never forget it - expect volatile markets over the next several years while the global economic cycle resets. Stay long, for long but never forget to buy when markets are cheap or sell when they are expensive - portfolio allocation is your greatest friend!