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Evenlode Investment View - November 2010

In Dr. Bernanke We Trust

Ben Bernanke on the latest round of quantitative easing, November 4th 2010:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stocks and bonds rose when investors began to anticipate the most recent action, and easier financial conditions will promote economic growth. For example, lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

The Federal Reserve has repeatedly made it clear over the past two months that it's ready to embark on a new programme of quantitative easing (‘QE’), and at the start of November it followed through on this promise. The Fed, however, is under no illusion as to the limitations of this blunt policy tool. As the above quote demonstrates, Bernanke knows that the main direct effect of QE is to lift the price of stocks and bonds, rather than stimulating the economy directly. The hope, as he says, is that the wealth effect created by low long-term interest rates and rising equity prices will be enough to spur the US consumer into life.

The first part of Bernanke's plan has certainly been working. The last few months have seen a rare combination of equities, bonds, oil, industrial commodities and precious metals rising in tandem. It's not so clear that the transition mechanism to the real economy is having as much success. When the Fed cut interest rates to 0% two years ago, it expected US unemployment would have fallen to 7% by now. When it embarked on QE for the first time in the first quarter of 2009, it expected unemployment to be 8% by now. Unfortunately, US unemployment has not got close to those levels - it still hovers just under the 10% level.

But 'Who Cares?!', is Mr Market's cry. In this looking-glass world, the worse it gets for the average individual, the better it gets for investors in financial assets. Negative news on the economy is taken as a positive sign that more QE is on the way. Bernanke and his wife, apparently, own one car between them - a Ford Focus. This is a nice irony: Ford Focus man is helping out, in a very significant way, a Wall Street constituency that wouldn’t be seen dead in one.

The other big beneficiaries of Bernanke’s largesse are the economies of the Far East. Countries such as Hong Kong and Singapore are, economically, on fire. These countries are experiencing GDP growth in the double-digits but, given their currency pegs, are still binging on a diet of monetary policy designed for an economy desperately trying to avoid slipping back into recession. It is no wonder that property prices and inflation rates in these areas are reaching uncomfortably high levels. In a similar vein, the statistics coming out of China continue to defy any normal economic logic.

As we see it, there are two huge economic experiments underway in the world right now. In the west, central bankers - with Bernanke leading the way - are embarking on a programme of monetary debasement without precedent in the post-Bretton Woods world of paper currencies, to stimulate their ailing economies. After completing the latest round of QE, the Federal Reserve’s balance sheet will be equal in size to 20% of US GDP. In the east, the Chinese government are investing unprecedented amounts of money in infrastructure projects to keep their economy growing. Fixed capital formation in China is running at more than 50% of GDP. Ten years ago it was only a third – it is a mathematical fact that this ratio cannot keep increasing indefinitely. There is an interesting parallel between these two experiments - both are forms of huge state-sponsored stimulus, and both need to ultimately end in a transition from government involvement to private investment. These journeys, while achievable, are unlikely to be straightforward ones.

Certain parts of the UK market, however, rely on these journeys being just that. And in the meantime, they are reliant on the support of government and monetary stimulus to survive and prosper. In particular, banking stocks are reliant on a continuation of yield curve manipulation (from Bernanke et. al.) for their profitability, while mining stocks are reliant - if industrial metals are to retain their current pricing power - on a continuation of the rampant Chinese construction boom. As a result, UK investors are implicitly placing a large portion of their capital in the trust of, on the one hand, Dr. Bernanke, and on the other, the Chinese Politburo.

We prefer to put our trust in businesses with some insulation from these economic complexities. The Evenlode portfolio holds no mining stocks and no banking stocks. On average it is debt-free, globally diversified, and priced to deliver cash-flow returns that, on an absolute basis, look very appealing to us. While we hope that the forthcoming transition from state-sponsored stimulus goes without a hitch - in all parts of the world - we are not relying on it for our future returns.

Hugh Yarrow
November 2010

Please note, this investment view contains the personal opinions of Hugh Yarrow as at 5th November 2010 and does not constitute investment advice.

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