QE2- don't bet on it, don't bet against it!

The rally in the emerging stock markets (especially those in the Asia Pacific region) for the past six months is driven both by improving economic performance & the huge flow of liquidity from developed countries (especially the U.S.). The sustainability of these economies is not a foregone conclusion as many are dependent on exports to the developed countries. The flow of funds from developed countries is very real & a large part of this liquidity inflow comes from funds managers who seek to gain exposure in non-USD assets (or corollary to avoid USD assets). This has created a sharp rise in the currencies of many countries (especially those in the Asia Pacific region) as well as the value of many assets in Asia Pacific, from stocks to properties. How sure are we that the liquidity flow will continue unabated?

The huge liquidity outflow from U.S. is due to Fed's much-publicized decision to buy long government bonds, the second such attempt to create inflationary condition in order to beat off the equally feared condition called deflation as well as to boost the weak U.S. economic growth. This policy move by Fed is called Quantitative Easing II or in short, QE2.

When QE2 was talked about openly a few months back, the quantum of government bonds to be acquired was in the ball park of RM1.0-1.5 trillion. Like the Obama administration, the Fed is mindful of the popular revolt in American heart land towards any government decision that would erode the value of the USD or lead to increased government borrowings. Now, the Fed has come out openly & confirmed that the amount to be spent on QE2 would be only USD600 billion. Is that sufficient? To make matter worse, the U.S. government had a hard time at the recent G-20 meeting when Germany, China, Brazil & a few other countries attacked the U.S. government decision which creates inflationary condition worldwide. For more, go here.

Finally, the World Bank has spoken out on a topic that was once considered taboo- the prospect of Asian countries implementing capital control in order to check the huge inflow of foreign funds. For more, go here. This would certainly provide the cover for emerging Asian economies to discuss & then jointly implement some measures that would check the liquidity inflow & the sharp rise in their currencies.

These two developments could potentially happen over the next few weeks or months which could lead to a reversal of the inflow. Once the inflow stopped, the stock market rally would weaken.