What does QE2 mean for your investments?

The US Federal Reserve is planning to pump another $600bn into America's ailing economy. Whether it will help the 'real' economy is uncertain. But it's already having an impact on asset prices. John Stepek explains what it means for your investments.

Federal Reserve chief Ben Bernanke delivered just what financial markets were looking for last night.

The Fed is planning to buy roughly $75bn of government bonds a month between now and the middle of next year. That's $600bn in total. Stocks went up, the dollar slipped back, yet gold didn't go haywire (although it's up again this morning).

So what does it all mean for investors?

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Why the Fed has started QE2

It's insane that the investment decisions driving our free-market financial system now boil down to what one bearded academic believes is the right amount of money to be circulating in the world. If central planning works this well, then maybe we should have the Fed set quotas for tractor part production too.

But that's the world we live in. So what is Ben Bernanke trying to achieve with this second batch of quantitative easing (QE2)? My colleague Tim Bennett gives the details in his latest video tutorial: What is quantitative easing?

The upshot is that QE is what central banks do when they can't cut short-term interest rates any further. (Over here, that's the figure that the Bank of England announces every month - currently 0.5%). With QE2, they try to cut the cost of longer-term borrowing by buying government bonds.

Why does the Fed want to do that? Because the US economy is still in a pretty miserable state. The main problem is high unemployment (nearly 10%). If borrowing costs fall, then the idea is that companies will borrow more to invest and consumers will borrow more to spend.

That's the theory. What's probably closer to reality is that the Fed has realised that, as a good friend of mine always says: "the best way to cure a hangover is to start another one." In other words, if an investment bubble bursts, the quickest route out is to inflate another one.

This is no way to run an economy

It's not clear what impact QE has had on the 'real' economy. But it's definitely had an impact on asset prices - the price of stocks, bonds and commodities. By driving down yields on the 'safest' assets, the Fed has pushed investors to speculate in more risky, marginal assets. Judging by the rise in stocks and the drop in the dollar following the latest announcement, that looks set to continue.

It's no different to the policy followed by Bernanke's predecessor, Alan Greenspan. Greenspan cut interest rates every time it looked like Wall Street was in trouble. Mild recessions were tackled using extreme monetary policy. As a result, a series of investment bubbles was blown, from tech stocks to property prices.

This is no way to run an economy. Why not? Jeremy Grantham of US asset management group GMO puts it well. He points out that if you keep the cost of debt low, then it means that weaker, less efficient, more deeply indebted companies can survive more easily.

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"If we look at the time frame since 2001, it is composed of two periods of negative interest rates with a bail-out in between. This whole era has been artificially favourable to marginal companies and leveraged companies, partly at the expense of conservative, un-leveraged blue chips." Why does this penalise good companies? Because they look less attractive compared to riskier stocks, and also, "they have missed opportunities for picking up failing companies that they would normally have acquired at attractive prices."

This is bad news. Handicapping quality companies in favour of ones that really should be bankrupt won't do your economy any good. And there are other dangers. As Grantham points out, artificially suppressing the dollar may lead to retaliation from other countries. For example, the Japanese central bank has rescheduled a meeting of its own (the results are due tomorrow) so as to respond to the Fed's latest move.

"Continuing QE2 may be an original way of redoing the damage done by the old Smoot-Hawley Tariff hikes of 1930, which helped accelerate a drastic global decline in trade." As my colleague David Stevenson points out, this danger has been heightened by the election results - with US politicians experiencing gridlock, protectionist policies might be one of the few things they can agree on.

But one thing's for sure. As long as Bernanke is in charge of the Fed, we won't see a change in policy. Given that the 'Bernanke put' is firmly in place, what should investors do?

Wider stock markets could keep rising - until the next crisis, whenever that happens. But like us, Grantham suggests being picky, and buying high quality stocks (defensives, basically) for the long run.

The best way to play QE2

If you're looking for a way to play QE2 which also has some genuinely solid fundamentals behind it, then you're best to look to 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. Our Asia expert, Cris Sholto Heaton is out in South East Asia right now researching companies to add to the portfolio of his Asia Investor newsletter. (You can read his latest views on Thailand in his free MoneyWeek Asia email here: Investing in Thailand? Opt for riskier stocks - here's why)

The good thing about Cris' research is that he's looking beyond the sorts of commodity plays and massive, state-backed companies that form the meat of many emerging market indices and exchange-traded funds. He's looking for the real value stocks that have the chance to grow and have drawn less attention than the more obvious plays.

MoneyWeek Asia is an unregulated product published by MoneyWeek Ltd. Asia Investor is a regulated product published by MoneyWeek Ltd.


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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.