Quantitative Easing, Commodities and Emerging Markets

In 1717, a convicted murderer and compulsive gambler became the most powerful man in France and exerted more influence over the economy than the nation’s king.

Born in Scotland to wealthy parents, John Law was convicted of killing a man in a duel in 1694 and sentenced to death. Law escaped prison and fled to Amsterdam where he became fascinated by the Dutch system of finance. He developed the idea of creating a national bank and monopoly trading company that would issue paper money and shares rather than the traditional gold and silver coins that were considered currency in most countries.

Law found a ready market for his ideas in France. A series of wars and the profligacy of Louis XIV had nearly bankrupted the state. In fact, shortly after Louis’ death, the government restructured the crown’s mountain of debts, a partial sovereign default in the parlance of our times. The government also inflated and debased the currency by periodically recalling silver and gold coins and inflating their value.

With the endorsement of the king’s regent, Law set up The Banque Generale in 1716 to issue bank notes that were ostensibly backed by precious metals. Over the ensuing four years, Law’s bank gained more influence and power. In 1717, the bank’s currency was established as the official currency for tax payments, and in 1718, the Banque Generale became the Banque Royale, with the implicit backing of the king.

Law also created a privatized French national trading company, Compagnie des Indes, or the Mississippi Company. The Mississippi Company was also granted shocking monopoly powers over trade with the nation’s colonies in the Americas. Through his bank and the Mississippi Company, Law effectively controlled France’s tax collection, mints and the entire national debt. And by issuing shares in the Mississippi Company to a European public enthralled with its growth prospects, Law created wealth out of thin air. In short, Law created a paper currency and inflated a stock market bubble.

As you’ve probably guessed, this grand experiment ended in tears. Shares of the Mississippi Company hit a wall, and speculators began to sell their positions. The selling accelerated as the stock price fell, forcing Law to resort to various methods of artificially propping up the stock. Growing suspicious of the banknotes’ worth, the public rushed to convert their holdings into gold and silver. Unfortunately, the French had inflated the quantity of banknotes well beyond the stocks of gold and silver that supposedly backed the paper money.

Paper currencies and shares ultimately depend on the confidence of their holders; Banque Generale’s banknotes and shares of the Mississippi Company were worthless by the end of 1720, ruining countless nobles in France and across Europe. Law was forced to flee France in disguise and died penniless in Venice in 1729.

18th Century Lessons in the 21st Century

Unfortunately, a similar tales is playing out today in the US, Japan and other developed countries. Over the past few weeks, speeches by various Federal Reserve governors have signaled that the US central bank is prepared to resume quantitative easing (QE) in an effort to reinvigorate the faltering US economic recovery. This isn’t the first time the Fed and other central banks have turned to QE; several central banks, including the Fed, employed QE as a policy tool during the 2007-09 financial crisis.

The practice of QE is simple. The Federal Reserve buys long-term government bonds from financial institutions with money created specifically for this purpose. Generally speaking, QE drives up the price of long-term bonds and pushes down yields. In addition, the policy injects cash into the banking system.

The theory is that lower long-term interest rates and more liquidity will stimulate lending and credit, the lifeblood of economic growth. In addition, by purchasing bonds with money that’s created out of thin air, the central bank essentially monetizes US government debt by buying that debt with inflated money.

QE can also involve the purchase of assets other than long-term government bonds. Earlier this week, the Bank of Japan proposed purchasing up to USD60 billion worth of government bonds, corporate debt and Japanese real estate investment trusts. Recent speeches from policymakers indicate that the Fed is considering the purchase of mortgage-backed securities and other assets in an attempt to directly boost asset values.

The size of the Fed’s balance sheet provides a good indication of the scale of its QE efforts to date.

Source: Bloomberg, Federal Reserve

The bonds and other securities that the Fed buys appear as assets on its balance sheet, a number that increased steadily from about $500 billion in the mid-1990s to just under $900 billion in mid-2008.

QE and other programs bloated the Fed’s balance sheet from 2008 to early 2010. In May 2010, the Fed’s total assets stood at more than $2.35 trillion–nearly triple the size of its holdings in 2008.

The Fed had planned to reduce the size of its balance sheet as the economy recovered and the need for extraordinary stimulus declined. But that scenario hasn’t played out according to plan. As economic data deteriorated in the summer, the Fed grew increasingly nervous about withdrawing monetary stimulus too early.

In August, the central bank announced that it would reinvest principal repayments from the securities it holds. In other words, as the bonds the Fed holds are paid off, the central bank will buy more bonds. This form of quantitative easing will ensure that the Fed’s balance sheet remains bloated. And the new round of QE would serve to further inflate the size of the central bank’s balance sheet; the current assumption is that the Fed is ultimately looking to purchase between $500 billion and $1.5 trillion in assets, a massive expansion by any measure.

Such a policy entails major risks and has significant implications for investors. The first and most obvious is simply that it won’t work or, at least, won’t have the desired impact. The goal of lowering long-term rates is to stimulate credit, but there just isn’t much demand for credit in most segments of the economy.

Source: Bloomberg

As you can see, US household debt exploded during the housing boom and now stands at around 100 percent of gross domestic product. Mortgage loans to households were possible on this scale because of the rapid rise in home prices and the faulty assumption that values wouldn’t fall appreciably.

But the US housing market is in tatters, and home prices have dropped precipitously in recent years. Although the pace of this decline has slowed and the housing market is showing signs of stabilizing, any recovery will be achingly slow. Home price appreciation no longer supports an expansion in consumer credit. And with household debt already sky-high, most US consumers are focused on deleveraging and paying down their debts.

Interest rates on mortgages are near all-time lows, but that hasn’t stimulated much growth in consumer credit. A further decline in long-term rates is unlikely to change matters.

Much the same can be said of small businesses in the US. Although small businesses generally have healthier balance sheets than many households, the Fed’s Senior Loan Officer Survey on Bank Lending Practices indicates that there isn’t much demand for businesses lending.

Source: Federal Reserve

As you can see, loan demand among small businesses continues to shrink despite low rates, while demand from larger companies has grown at a snail’s pace.

Corporate bond markets are a different story. Companies large enough to raise capital through new bond issues can access credit at extraordinarily low rates. In September, US corporations issued more than $164 billion in bonds, the largest monthly total since May 2008 and roughly in-line with issuance at the height of the credit boom. Meanwhile, rates are hovering near record lows; the average yield on a 10-year bond of a BBB-rated industrial company stands at less than 4.8 percent.

Most large US corporations have relatively little debt and, in many cases, high cash balances. They’ve also taken advantage of low rates to pay off short-term debt and reduce their exposure to credit lines. But it’s unclear how much of this cash ultimately stimulates the US economy.

Certainly, cheap money is fueling a pick-up in merger and acquisitions in many industries, a trend that’s likely to continue. This has also allowed companies in some industries to raise capital to fund domestic growth. For example, many of the master limited partnerships that Roger Conrad and I cover in MLP Profits are using cheap debt capital to build badly needed energy infrastructure such as pipelines and storage facilities.

But with the US economy continuing to languish, the best investment opportunities are abroad and in the emerging markets. It’s likely that much of the cheap capital raised in bond markets will be used to fund overseas expansion; the flood of liquidity is great news for emerging markets but not for the US economy.

The flood of liquidity will also result in inflation, albeit not the kind with which most investors are familiar. Domestic US industries and markets are beset with plenty of excess capacity, making it unlikely that prices will rise. For example, wages are unlikely to head higher while the unemployment rate is near 10 percent; there are plenty of excess workers to handle any increase in demand. The deleveraging underway is inherently deflationary.

In contrast, markets exposed to global demand–most notably commodities such as oil, grains and metals–are in tighter supply because demand from emerging markets continues to grow. That flood of liquidity is likely to push up commodity prices significantly in coming months.

The longer-term and more serious risk of QE is that it could undermine the entire paper money system, just as it did in 18th century France. If foreign holders of US government debt lose confidence in the nation’s ability to repay its obligations or become convinced that the Fed is planning to monetize its debt and devalue the US dollar, these holders will demand higher interest rates to hold US government bonds. Such a development would increase long-term interest rates and precipitate a collapse in the value of the dollar.

I also question the need for QE. As I’ve written in Personal Finance Weekly for well over a year, the US is in the midst of a subpar economic recovery from the vicious 2007-09 recession.

Data suggest that the US economy has exited the soft patch it hit in May. For example, although Friday’s headline payrolls data was worse-than-expected, the shortfall was almost entirely due to Census and local government layoffs. Private payrolls growth was in-line with forecasts, and if we consider the revisions to prior month’s data, private-sector jobs growth came in toward the high end of expectations. Growth will remain anemic, but the US economy is in little danger of entering a recession in the final months of 2010 or early in 2011.

But for better or worse, another round of QE is likely by the end of this year or early in 2011, regardless of future economic data. The combination of QE, improving economic data and market-friendly results in midterm elections should lift stocks into year-end. I expect the S&P 500 to hit new 52-week highs before 2010 is in the books.

This is all great news for stocks leveraged to global commodities and growth in emerging markets. In the most recent issue of my paid service, The Energy Strategist, I recommended a list of stocks in the crude oil, coal and uranium mining industries that will benefit from the coming commodities boom. Commodities and related stocks will also provide a much-needed hedge for those concerned about the ongoing devaluation of the US dollar and the long-term stability issues raised by quantitative easing.

Readers interested in reading about my top energy picks can click here to sign up for a free trial of The Energy Strategist.

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