“Money may no longer be physically printed and distributed in the voluminous quantities of 1923. However, ‘quantitative easing’, that modern euphemism for surreptitious deficit financing in an electronic era, can no less become an assault on monetary discipline. Whatever the reason for a country’s deficit – necessity or profligacy, unwillingness to tax or blindness to expenditure – it is beguiling to suppose that if the day of reckoning is postponed economic recovery will come in time to prevent higher unemployment or deeper recession. What if it does not? It is alarming that some respected bankers and economists today, in the US as in Britain, are still able to commend ‘the printing press’ (in so many words!) as a fail?safe, a last resort. A country’s budget can indeed be balanced in that way, but at the cost, to whatever degree, of its citizens’ savings and pensions, their confidence and trust, their morals and their morale.” Adam Ferguson (2010)

As was widely anticipated, the Federal Reserve has decided to resort to a new round of quantitative easing. “QE2”, announced on Monday, will take the form of buying around 75 billion dollars of government bonds per month from now to the end of June 2011. Added to these new purchases will be some 30 to 35 billion dollars of coupon reinvestments which were expected anyway. The Fed’s objective is to create a wealth effect by inflating the value of financial assets and real estate prices which will then stimulate consumer spending and investment. In so doing, it is perpetuating the disastrous policy that began in the Greenspan era in the mid-1990s, which was in large part responsible for the structural problems that the United States is currently experiencing. Maintaining interest rates at artificially low levels has provoked a poor allocation of resources that has encouraged speculation to the detriment of productive investment. The Federal Reserve has thus confirmed that it has become a danger to the long-term economic health of the United States.

Unfortunately however, the decisions of the Federal Reserve ? the central bank of the principal reserve currency, the dollar ? do not only affect the United States but have repercussions across the global economy. As soon as the Fed signaled in August its intention to embark on this new round of quantitative easing, the dollar depreciated massively. Its decline was particularly marked against the euro given that the Asian currencies, the logical candidates for appreciation in view of their good fundamentals, are more or less correlated to the dollar. By encouraging, explicitly or not, their currency to depreciate in order to stimulate their exports, the United States are adopting a form of protectionism that is in danger of aggravating the global economic problems. In this regard it is ironic to note that, by pushing up commodities prices, the fall in the dollar is further increasing the problems of the American consumer ? witness, for example, the price of oil which has gone up by nearly 18% in the last two months.

USD/EUR exchange rate over 1 year

For fund managers, QE2 poses an additional problem. It is likely to prolong the decorrelation between the financial markets and economic reality. While a casual observer could thus think that the 16% rise in the US stock market since the end of August is based on improved economic fundamentals in the United States, in reality, this increase began with the announcement of further quantitative easing to come by the Fed’s chairman, Ben Bernanke. And, it is precisely because the economy is in such poor health that the central bank has decided to resort to this form of monetary stimulus.

S&P500 over 1 year

This divergence between the direction of the financial markets and that of the real economy could continue for some time to come (technically, the fact that the S&P500 has crossed the 1220-mark seems to be a positive signal). If it does, it is likely to test the patience and discipline of many investors who risk succumbing to the temptation of chasing the upswing, especially in an environment of very low interest rates. As many professional investors are judged on the performance of their portfolios against stock market indices, they feel cornered into taking risks on account of the monetary policies of the central banks, especially the Fed.

Trying to hook into short-term stock market runs is not an investment strategy however, especially when the trends are already well advanced and not based on solid fundamentals. The best way of protecting one’s capital and making it grow is to buy good quality assets at reasonable prices without being unduly swayed by the markets’ daily fluctuations. It is not a question of being bullish or bearish about equity markets but of identifying investments within these markets that meet this criteria. The themes to focus on remain the same:

• emerging markets either by investing directly in the financial markets of these countries (nevertheless being aware that the local market indices are not necessarily a good way of investing in Asian growth given that they are often dominated by exporting companies), or via American or European companies that derive a significant portion of their revenues from these countries;
• companies paying attractive dividends;
• quality companies given that the premium at which they generally trade compared to the market and compared to lesser quality companies has disappeared.