October 20, 2010

Global stock markets have been buoyed during the last month by reports of impending quantitative easing by leading central banks. These efforts come in the wake of evidence of a slowing in the global economic cycle, and in the case of the United States and Japan, deflation concerns. With commentary from some camps within the Federal Reserve that increased inflationary pressures would be welcome, the Fed has clearly decided that the risk of inflation is manageable, while the risk of deflation is unacceptable. They have also likely realized that monetary policy has to carry the bulk of the load in this political environment. This is relatively uncharted territory for both investors and policy makers, and the likelihood of unintended consequences is high.

As developed economies such as the United States, the United Kingdom and Japan pursue ultra-low interest rate policies to try to stimulate growth, distortions in global capital flows and currency markets result. Asian countries that peg their currencies to the dollar, such as the Chinese renminbi and the Hong Kong dollar, benefit from U.S. dollar depreciation while other emerging economies, such as Brazil and South Korea, see their currencies appreciate and their exports become less competitive. These frictions are creating the increased risk of a currency war — which would compound the level of risk around the necessary rebalancing of the global economy.

While the anticipation of this quantitative easing has improved financial conditions through lower interest rates, depreciated currencies and higher equity prices, we aren’t convinced that it will meaningfully increase economic activity. If it does, it will be because of increased bank credit issuance or stronger confidence driven by an improved stock market. There’s a strong correlation between stock market returns and consumer holiday spending, and corporate confidence would surely be bolstered by higher stock prices. In this way, the stock market can become more of a shaper of future economic events than a discounting mechanism.

U.S. Equity

• Increased risk taking has driven equity markets higher
• Underlying fundamentals haven’t meaningfully changed

EAFE and Emerging Markets

• Dollar weakness has significantly affected the euro and yen
• Global tensions over currency values could be disruptive to growth

Fixed Income

• The return of 100-year credit issuance is a favorable development
• The strong credit environment is underpinned more by low rates than tight credit spreads

High Yield

• Debt issuance is increasing for purposes that weaken issuer credit quality
• The surplus of cash coming into the markets is fueling these financings

Global Real Estate

• Global real estate investment trusts (REITs) posted a total return of 9% in September, as Europe and Asia rebounded strongly
• Global real estate has become expensive based on net asset values and cash flow

Hedge Funds

• Hedged equity managers gained 4.5% in September, bringing many managers into positive territory year-to-date
• Hedged equities significantly outperformed traditional indexes during the past decade

Commodities

• Weather volatility continues to wreak havoc in agricultural markets

Conclusion
The significant level of policy intervention in today’s global economy is distorting normal economic relationships. Low interest rates in the developed markets push more capital flows toward emerging markets and force investors to seek yield.