HOW will you know whether the Federal Reserve’s plan to reinvigorate the economy by buying Treasury debt is working?
Simple: Look at how foreign stocks are behaving. Based on their performance last week, the Fed could be running into a problem.
Although one goal of the Fed’s $600 billion monetary stimulus is to restore confidence in domestic stocks — in the hope of bolstering consumer confidence and spending here at home — the real canary in the coal mine for the central bank’s plan is the performance of overseas equities.
Why? Market strategists say they believe that the Fed’s effort, its second foray into quantitative easing, known as QE2, will have several consequences, some of them apparently unintended. For starters, by keeping market interest rates low through buying intermediate-term Treasuries, the Fed hopes to prompt risk-taking among investors.
But risk-taking doesn’t stop at America’s shores, and since anticipation of QE2 began building, investors have bid up risky emerging-market stocks more than domestic equities. Since Aug. 31, the Morgan Stanley Capital International Emerging Markets Index has surged more than 13 percent. That strong rally is a sign that the Fed’s efforts packed initial punch, because it encouraged investors to take on risk.
Low interest rates also reduce demand for the dollar, though it has been rising quite recently. Over the longer haul, a falling dollar would lower the cost of American goods sold abroad, increasing exports and, ultimately, job creation.
But a declining dollar would also “encourage U.S.-based investors to favor overseas investments,” said Jeffrey N. Kleintop, chief market strategist at LPL Financial in Boston. That’s because when the dollar sinks against other currencies, investors who put money to work abroad can profit on the currency exchange.
Since Aug. 31, the MSCI EAFE index of foreign stocks in developed markets has gained 5.9 percent. But despite the dollar’s strength in November, the weakening of the currency in September and October nearly doubled those gains: 10.1 percent for Americans investing abroad.
Ultimately, the Fed’s goal is to reflate the economy. That means producing inflation, perhaps by accelerating economic activity and setting off greater demand for goods and services. Because many emerging economies in Asia and Latin America are big producers of natural resources, increased consumption in the United States — and rising prices of commodities — should provide a nice lift to many stocks in those regions, market strategists say.
“QE2 should help stocks in general, but it will probably help foreign stocks more,” said Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago.
Until recently, that was clearly the way it looked. Since the markets started pricing in QE2, the trends have generally worked in favor of foreign stocks.
But now comes the first real test. The Fed’s stimulus plan has begun to run up against another strong force: tightening monetary policies emerging in China.
Last week, speculation grew that China would raise interest rates further as government figures indicated that overall inflation for Chinese households rose 4.4 percent over the last year while food costs spiked more than 10 percent.
So far, officials in China have discussed imposing price controls, and its central bank has increased reserve requirements for financial institutions, in an effort to curb lending.
The fear is that if China must raise rates, “people will start to worry about a hard landing in China,” said Alec Young, international equity strategist at Standard & Poor’s Equity Research Services. And because China is such a huge consumer of commodities, that in turn could hurt growth in other emerging markets.
Indeed, since Nov. 9, when the worries about China began to crop up, commodity prices have sunk around 6 percent and emerging-market stocks have been off around 5 percent.
Contributing to fears of another economic speed bump is the fresh round of concern out of Europe, with the talk of a financial bailout of Ireland. And, last week, geopolitical news came back into the financial mix, with North Korea’s military strike on a South Korean island.
“It’s hard to be pounding the table in positivity with these things in the news,” Mr. Young said. He added that the rekindling of fear in the global economy recently caused the dollar to strengthen and commodities to fall.
For now, many market strategists are still betting that the Fed’s spending can trump the potentially troubling headlines emerging from China and much of the rest of the world.
“You never see the positive news in headlines, like that Sweden is recovering nicely or how healthy Germany’s economy is,” said David R. Kotok, chief investment officer at Cumberland Advisors.
What’s more, Mr. Kotok says Chinese officials are well aware that they must balance their policies’ effects on their domestic economy and on Western markets, a huge source of demand for Chinese goods and services.
Furthermore, Mr. Kleintop at LPL says he believes China’s efforts to combat inflation won’t lead to a hard economic landing. Rather, he predicts a “very modest and targeted” slowdown that won’t negatively affect emerging-market growth or the success of the Fed’s plan. Of course, if it does, investors in those foreign equities will be first to notice.
Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.
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