Quantitative easing risks stoking a bubble in emerging market equities


CTATIONS of another round of quantitative easing in the US had been riding high for several months and last week Helicopter Ben gave the markets exactly what they had been clamouring for. Investors across the world wildly applauded the Federal Reserve’s decision last week to pump $600bn into the US economy and needed little excuse to keep the switch firmly flicked to risk-on and continue the party. Since then, stock markets climbed to the heady levels last seen in the summer of 2008 while Brent crude oil rose to more than $88 a barrel, its highest since early May.

The Fed might be keeping investors upbeat but not everybody was so enthusiastic about more quantitative easing. Although emerging market policymakers have softened their stance ahead of this week’s G20 meeting in Seoul, they initially slammed the Fed’s actions. Even Germany has gone as far as labelling QE2 irresponsible.
But the sceptical permabears are also growling a note of caution, arguing that further quantitative easing is more likely to boost emerging market equities – already at 30-month highs – and commodity prices rather than stimulate the American economy.

The International Monetary Fund’s (IMF) chief economist Olivier Blanchard argued at the end of last week that the second round of QE will intensify flows into emerging markets by reducing the carry trade risk. Gluskin Sheff’s permabear David Rosenberg agrees: “The flip side of the decline in the dollar is that global capital flows to emerging markets are surging and this has taken the Thai baht to a 13-year high.” Rosenberg points out that the inverse correlation between the dollar and emerging market equities is very strong, at 90 per cent in the past six months and 92 per cent over the past two months. With QE expected to put more downward pressure on the dollar, further upside ought to be expected for emerging market equities at least in the near-term.

Investors expecting another a leg higher in emerging market indices and commodities should be careful, however. For a start, policymakers are looking increasingly keen on pursuing capital controls as a means of stemming inflows and dampening inflationary pressures. Such policies would limit any increase in equity prices.

Furthermore, unfavourable comparisons are already being drawn between the current Fed-inspired, indiscriminate buying of emerging market equities and the liquidity-fuelled equity bubbles in the mid-1990s and in 2008.

While bubbly markets are perhaps a natural consequence of the divergent growth paths of the advanced and emerging economies, QE2 is artificially giving them a helping hand. India is trading at an average price-to-earnings (p/e) ratio of 19 times, while China is at 15 times and Brazil 13 times.

Societe Generale’s Albert Edwards says: “Despite all this liquidity pouring into emerging market equities, they are just another high beta trade, outperforming on the way up and underperforming on the way down.

He adds: “The simple fact is that if, as I expect, QE2 fails and fiscal tightening sends the fragile western economies back into recession, we will see the unfolding liquidity-driven emerging market and commodity bubble burst just as violently as it did in the second half of 2008.”

While QE2 continues to convince investors, emerging market equities will remain well supported. But as we saw in both the mid-90s and in the more recent financial crisis, investor optimism is all too quick to evaporate. Investors should consider themselves warned.