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All aboard the QE2

After hitting a low of around 4,800 in July, the FTSE 100, along with most other markets, has been moving up strongly, climbing the wall of worry.

Even September and October, months that are notorious for their volatility, treated investors well. With such a difficult economic backdrop, I am sure many are questioning why this should be.

Yet most of the problems we see are to do with government and consumer debt. True, these are worrying issues but broadly speaking companies are in good health, having started putting their houses in order almost as soon as the financial crisis hit. Not so governments, some of whom are still procrastinating and inclined to spend more money rather than less. Meanwhile, consumers have been gradually getting the message and paying back debt.

One of the main reasons I believe stockmarkets have been moving up is the possibility of a fresh round of quantitative easing, or QE2 as it has become known. Essentially, QE results in new money being created and allowed to circulate in the economy. The idea is to give economic growth a kickstart. I have no particular view as to whether this is the right or wrong action but it could produce some interesting consequences.

Given the severity of the financial crisis, it is hardly surprising to see a period of weak growth. It is only natural and I expect it to continue. Yet politicians and central banks on both sides of the Atlantic seem loathe to accept this and are looking around for a cure for the problem.

Unfortunately, QE is a medicine that has not been tested on its patient before. It is debatable whether it will work in the way it is intended or will produce different, entirely unintended, effects. It could, for instance, have an impact on financial assets, driving up prices without any effect on the real economy. In particular, I suspect it could be a shot in the arm for emerging markets rather than for those economies implementing QE.

This should not come as a surprise. Money, like water, flows along the path of least resistance. If you can discover where that is you have found your pot of gold. And, if you will pardon the pun, gold is surely one of those places at the moment along with other commodities and emerging market equities. These are seen as the most exciting, high-growth areas, so investors have already been turning their backs on traditional Western markets to pour money into these markets.

Financial commentators have picked up on this and I am increasingly seeing the word “bubble” used in conjunction with gold and various emerging economies. I have no doubt that some assets look overbought but I think calling it a bubble is much too premature.

Gold is rising because of the debasement of currencies caused by QE and, with interest rates so low, there is little opportunity cost incurred by holding it. If it doubles, I will probably change my mind but for now I see the price movement as rational rather than irrational. Meanwhile, emerging market equities, while not cheap, do not look particularly overvalued to me.
A well known expression says it is always better to travel than to arrive and I feel much of the QE effect must have been discounted already. If we do see a correction in the markets, I would be a buyer of the dips, particularly in emerging markets and gold.

I feel there is at least one more leg to go in this market rally, so I am still a fan of Aberdeen emerging markets, BlackRock gold & general, Neptune Russia & Greater Russia and First State Latin America. Investors will need to keep an eye on valuations and be prepared to jump ship but in the meantime, I think this is a buy in the dips market.

Mark Dampier is head of research at Hargreaves Lansdown

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