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How New QE Will Launch Emerging-Market Stocks - Outside View by Martin Hutchinson

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How New QE Will Launch Emerging-Market Stocks
Oct 14, 2010

In Wall Street circles, it's known as "QE2" - for "Quantitative Easing - Round 2."

The U.S. Federal Reserve and the Bank of England (BOE) are moving rapidly towards it, and the Bank of Japan (BOJ) has pledged to enact it.

That Bank of Japan pledge ignited a $23.50 spike in the price of gold on Tuesday. But that's nothing compared to what would happen after a Fed move. An additional easing by the U.S. central bank would cause gold and commodity prices to spike - and emerging-market stock markets to soar.

We should be prepared for this eventuality.

The "Race to the Bottom"

All this talk of "quantitative easing" refers to the printing of money to buy up U.S. Treasuries, mortgage bonds and whatever else needs supporting on the bond markets. The Fed opened the door to it at its last meeting, and there is talk that QE2 will involve bond purchases totaling $1 trillion.

The Bank of England's Monetary Policy Committee is split on the subject - even though Britain's inflation rate is above the BOE's target range. The Bank of Japan on Tuesday reduced its short-term rate to zero and pledged to carry out a $60 billion asset-purchase program.

It's possible the three central banks will pull back from this policy. But it's more likely that they will undertake coordinated action in this direction. Only the European Central Bank (ECB) - dominated by conservative Germans - seems likely to hold out.

Believers in "stimulus" programs in the three affected countries are thrilled that this could play out. In reality, however, it's bad news.

Printing money to buy bonds - primarily government bonds - will tend to fan the inflationary flames. The surge in liquidity will also inflate bubbles - such as the one we're currently seeing in the U.S. junk bond market, which during the first nine months of 2010 saw more issuance than any previous full year.

It will also encourage governments to run even bigger deficits, because they will be easier to finance with the central bank buying bonds. This is not an immediate danger to state solvency in Britain or the United States. But it is a very immediate one in Japan, where government debt is approaching the highest levels that have ever been successfully managed in modern history.

If Japanese policymakers don't like Japan's current economic position, wait till they see the one that would be caused by a default on $10 trillion of Japanese government debt.

The real secret is that the extra monetary stimulus won't do much good in Japan, Britain or the United States because interest rates in all three countries are already very low - indeed, too low for the health of the economies concerned. Indeed, with all three countries printing money, their currencies will likely compete in a "race to the bottom" - with each nation trying to stimulate its domestic economy by being weaker than the others.

It's a pretty dire signal when it's Guido Mantega - the socialist Brazilian minister of finance - who blows the whistle on this impending currency war.

Ode to the Emerging Economies

Although this flood of new money won't find a home domestically, it will find places to settle down in many of the emerging markets.

Emerging markets, by and large, have lots of cheap labor, but lack capital. Because they have only modest domestic savings and are somewhat unstable, interest rates are generally higher than they are in counterpart Western countries. In Brazil, for example, the short-term Selic interest rate is 10.75%, compared to an inflation rate of only about 5%. That means financing expansion is expensive, so growth is slowed.

However if the world's central banks increase the global money supply, the extra money heads for the markets where the best profit opportunities exist. Some of this money will inevitably find its way into domestic junk bonds and leveraged buyouts (LBOs), but most of it quite rationally heads for the higher returns available in the emerging markets.

That's very good news for emerging-market stock markets - at least in the short run, before inflation becomes a real problem - and for two very good reasons.

First, the extra money increases growth rates and incomes, benefiting the earnings of companies selling to domestic consumers. Second, that liquidity infusion pushes up local stock markets, raising Price/Earnings (P/E) ratios. With both earnings and P/E ratios rising, the profit potential is enormous.

Action to Take: If the world's central banks pursue the "QE2" strategy ("Quantitative Easing - Round 2"), then by all means buy some more gold and watch the price rise as investors flee from all the "funny money" sloshing about in the U.S. market.

But don't forget to also increase your allocation to emerging-market stocks - where you'll find the extra money gives you a doubled effect on the growth of your portfolio.

This article is authored by Money Morning, a leading source of investment news research for the global markets.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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