What if the Fed disappoints with ‘QE2’? :: UBS

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1) What if the Fed disappoints with ‘QE2’?
Asia ex Japan equities have re-rated since September partly on the expectations
that the Fed would renew the expansion of its balance sheet (“QE2”) in the
upcoming FOMC meeting on 2-3 November (Chart 1). This is in line with our
long-held view that super-loose monetary policy is very positive for Asian
equities. One of the most common questions we have received has been what
the market has already priced in, and what could happen if the Fed disappoints.


Whilst it has become consensus that the Fed will launch QE2, there are debates
over how the Fed would do it. The question is whether the Fed will try to
‘shock and awe’ the market by committing to buy a large amount of Treasury
securities over a long period, or take a quarter-to-quarter approach in deciding
how much it will buy and for how long (our US economists’ view). Given the
sharp asset price moves since September, there are worries that the latter could
be perceived as a ‘disappointment’ by the market and could lead to a correction.

What are we expecting, and what is the market pricing in?

Our US economists’ view is that the Fed will purchase US$100-200 billion of
Treasury securities per quarter, and the program will be reviewed quarterly
(Imagining the shape of QE2, 8 October 2010 by Drew Matus).
To put this into context, the Fed has estimated that every US$500 billion of
‘QE’ pushes down long-term interest rates by 50-75 basis points (speech on 1
October by William Dudley, President and CEO of the NY Fed). Since 3
August, when the press first reported the Fed may stop shrinking its balance
sheet (this was subsequently announced by the Fed on 12 August and had led to
speculation that the Fed may launch QE2), the 10-year Treasury yield has fallen
by 21 basis points (Chart 2). Using this very crude measure, the market could
be pricing in US$140-210 billion of asset purchases. There have also been
larger figures (US$500bn and above) put forward by the press as the ‘consensus’
estimate. The wide range of estimates suggests to us the imprecise nature of this
exercise, both with estimating the impact of asset purchases on interest rates and
with trying to determine a date when the market started to ‘price in’ QE2.


Implications for Asian equities
In the very near-term, there is a risk of a ‘sell the news’ correction. Asia ex
Japan equities have gone up almost continuously since September. We suspect
some market participants will be tempted to take profits.
Which sectors in Asia ex Japan equities could be most at risk? Our short answer
is the sectors that have gone up the most in response to QE2. In Table 1 we
show the top 10 performing MSCI countries, industry groups and countryspecific
industry groups since August.
Currency strength contributed significantly to the performance of the Philippines,
Thailand and India markets – a reaction to a ‘disappointing’ QE2 could be a US
dollar rebound which could affect these markets.
Amongst the country-specific industry groups, Singapore Consumer Services
(Genting Singapore) and HK Capital Goods (Hutchison) performed well largely
because of company-specific factors. Korea Energy (SK Energy, GS Holdings)
and Thailand Materials (Siam Cement) benefitted from stronger oil price and
refining margins which were arguably driven by expectations of QE2. HK
Diversified Financials include only HKEx. The latter industry groups could be
vulnerable in a market correction.


Looking beyond the next week, the backdrop for Asia ex Japan equities hardly
changes whether there is a ‘shock and awe’ or more incremental approach in
implementing QE2. The key to us is that the Fed has deepened its commitment
to keeping interest rates low for an extended period of time, and Asia with its
relatively strong growth and penchant for stable exchange rates will be directly
importing inappropriately loose monetary policies. As long as there isn’t a
reversal towards tighter liquidity in the US or pick-up in inflationary pressure
that forces the Asian countries to tighten, over the next couple of years this
macro backdrop could prove very positive for Asian equities.