QE 3: Winners And Losers

by: Seth Walters

QE 3

QE3 has come, and come stronger than expected. Some people are speaking derisively of "Helicopter Ben" and how the central banks of the world are mad, simply mad, to keep printing all this money. There are whispered undertones and shadowy internet ads floating around everywhere about global financial collapse, often associated with exhortations to purchase gold and sometimes silver. Fear is the watchword of the day, and many are quick to react out of that fear. Furthermore, the Fed knows exactly what effect its actions are likely to have, but, in my analysis prefers to keep real public understanding of what it is doing to a minimum, for reasons which I will explain later on. Fear and ignorance can only flourish in such a climate.

Some Americans think the best asset the United States can have is a strong dollar, and pine for the days when a quarter could buy a gallon of gasoline. Some people think the best assets for people to own are "hard money" like gold or silver, because "the government" can't devalue them by printing more money. But a hunk of metal, or even a lot of hunks of metal, cannot make you a sandwich. It cannot carry you from place to place, nor can it keep your stomach full when you are hungry and thirsty. It cannot dream or think or grow or innovate or give you something wonderful you never even knew could exist. Only the labors of people can do these things. The time and energy and sincere effort of people, and the capital goods and energy that let them leverage this time and energy and effort - these are the only assets that really matter and are truly worth having in the long run, in my opinion. And you can only buy so much with fear.

You may be wondering what this has to do with QE3. Well, it's fairly simple. QE3 is essentially printing of money, which typically causes inflation. Well, what does inflation really do? Is it good or bad? Well, the truth is that it is both. Inflation in a way creates incentives to do more current and future work, but it also punishes past efforts by making some accumulated financial assets less valuable. The way that it does this is pretty simple. The total pie of goods and services that can be bought with all the money existing at any one time is the same size regardless of how much money there is. Thus, printing additional money dilutes the purchasing power of each unit of money. However, the sum total of all the money can still buy all the stuff that all the money could buy before. So, while printing money is dilutive, it is also a zero sum game. The main effect of money printing is therefore redistributive, rather than additive or subtractive. It accomplishes this through two mechanisms. One of these is to devalue debts. The other is to increase wages.

How on earth could this be desirable? Isn't bald-faced redistribution of wealth an anti-capitalist, anti-free market, and terrible idea? Well, let's consider a sample case. In this case, our sample American has $50,000 in debt and $50,000 worth of assets (mostly housing equity). He makes $20,000 a year after taxes, and it costs him $3000 a year to service his debt. He has $17,000 in "base living expenses". Under these circumstances, this guy is never going to make any financial progress at all if nothing changes. Every year he puts $3,000 into paying his creditors, and $17,000 into the economy. He would like to spend more but he just can't. His credit cards are maxed out and he has no extra money left over.

Now, let's print a bunch of money to inflate prices 100%, as a thought experiment. There is a danger here, and that danger is that our sample American's wages do not keep up with price increases of daily goods in the course of inflation. This is going to be of greater concern the more outsourcing there is. However, a dollar that falls faster than other currencies should also make American workers more competitive in the world market, and this should promote the increase of wages. If

(% change in wages) / (% change in consumer prices) < 1

as a generalized response to inflation, then there is a squeeze on the working poor and nonsavers (which is much of America), and consumption would be predicted to drop. This could be very bad, as it could start a downward economic spiral, with less consumption leading to lower profits and thus less hiring. But if we suppose that wages are able to keep up with prices under our inflationary example, we also have 100% wage inflation. Under these conditions, our sample American now has $50,000 in debt, $100,000 in assets, and makes $40,000 a year after taxes. It still costs him $3000 a year to service his debt, but his living expenses are now just $34,000. Wait a minute. Something has changed. He now has more in assets than in debt. And he's now got $3000 a year extra in his pocket after taxes. Where did that extra three grand a year come from? Well, we doubled everything, except for the debt principal and amount to keep the interest paid. Now he has money to buy extra things, and that can grow the economy. He can also pay down the principal on his debt. Let's say the first year he spends $1500 extra, which grows the economy, and $1500 to knock down his $50,000 debt principal. That gives him $1500 more net assets, and allows him to spend an additional $90 from saved debt-servicing costs that year, on stuff to stimulate the economy. Because the economy is growing his wages should be able to go up a little bit, especially if he is doing more work or learning more skills. But even if his wages don't go up in real terms and everything else stays the same he still gains 3% more net assets every year, and is also spending over 4.4% more the first year. This guy isn't alone though. There are hundreds of millions of more in varying financial circumstances, but if any of them have debt, any inflation will help them be able to spend more to grow the economy, because it will devalue the debt in real terms. It's also worth noting that the extra money in the economy may make it possible for our sample American to refinance his debt at a lower rate, boosting his spending power even more. What we have effectively done in this scenario is to turn a stagnant contribution to the economy on the part of an individual into a growing contribution, and we accomplished that by inflating away his debts. In the end, everyone wins when the economy is growing strong and humanity is making strides of progress. But, of course there are also short and medium term winners and losers as a result of this action. Well, who are they?


In simple terms, devaluation of debt helps anyone who has significant amounts of debt. This goes for individuals and it goes for companies too. Thus, a company like Apple (AAPL), which carries no debt but large amounts of cash, will actually be helped much less by QE3 than will leveraged companies. I think this is at least part of the reason that AAPL only gained 1% in response to the QE3 announcement last week, underperforming the S&P 500 and the Dow. Apple (and all equities) will however be very much helped by a growing economy in general, just not as much as leveraged companies, due to the debt devaluation issue. For example, General Electric (GE), has over $600 billion in total liabilities, and just $116 billion in net assets. Having even a relatively small % of those debts inflated away will have a great effect on GE, making the price-to-book ratio go down and the amount of money GE has to spend go up, just like it did for our American guy originally making twenty grand a year. Just 1% of debt reduction for GE should add over 5% to its net assets. Royal Bank of Scotland (RBS), International Business Machines (IBM), Wells Fargo (WFC), HSBC Holdings (HBC), JP Morgan (JPM) and Philip Morris (PM), like General Electric, also all have market cap above 150B and debt-to-equity ratios of above 100%. I would therefore expect these companies' equity growth prospects to have a long-term aggregate advantage over their less indebted peers in that market cap category, which would be stronger in proportion to the inflationary effect from QE. I believe that research along the theme of more heavily leveraged companies outperforming their less leveraged peers due to debt reduction-by-inflation could help identify an element of alpha, although obviously some due diligence will be required here. In general, I think the most heavily indebted firms will get the greatest alpha from this effect. In particular those firms that hold mortgage backed securities will obviously benefit from the Fed's purchase of them.

I would in general argue that an assortment of large- to medium-market cap companies (which the investor has otherwise done due diligence on, to make sure their fundamentals are sound), that also have high debt-to-equity ratios, are an excellent hedge against QE3 and inflation in general with the debt itself providing an inherent source of alpha to the investment. I consider such an investment to be much better than gold or any other hard commodity as an inflationary hedge. While gold and silver should at best rise with prices in general, debt laden equities should rise more. This is because such equities benefit both from economic growth-related increasing corporate earnings, and also from the direct inflation-induced devaluation of corporate debt.


On the other hand, companies that don't carry any debt will obviously benefit less. This doesn't make them losers, but it does make them less of winners. Companies that hold almost all of their assets as debt that they collect interest on, while holding no debt of their own, should be particularly hurt by inflation. I am talking about lenders like Visa (V) and Mastercard (MA), both with no debt of their own and loaded down with assets - much of which has to consist of money that people owe them.

However, even those two equities should have an element of better performance due to the improved economy that at least partly counteracts the real losses I would expect them to feel due to debt devaluation, and so they are likely better off than bonds. Bonds, and debt in general, are the worst asset class to hold during a time of inflation, as I see it.

Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) are also ultimately going to be big-time losers, in my opinion. In the short term, they should move up to keep pace with inflation more or less... but in the medium and longer term, as the economy truly recovers and fear goes away, I foresee a greatly reduced demand, combined with increased supply that has grown on the backs of companies like Barrick Gold (NYSE:ABX), Silver Wheaton (NYSE:SLW) and countless others, combining to create a dramatic plunge in the currently elevated prices of these precious metals.. and very likely of the undiversified companies engaged in their extraction. The price of gold may never touch $300 an ounce again, but I see no reason why it couldn't get that low again in inflation-adjusted terms. So, expect to see a bounce in these valuations for a while, but don't expect the current prices to last forever.


In summary, I feel that QE3 and other future inflationary measures, regardless of how the inflation is camouflaged, will end up helping the economy in the long run, by providing some badly needed debt relief to our debtor nation. I think part of the reason the Fed is being so abtruse about the issue is not because of any nefarious designs as I have seen speculated about, but rather because the Fed does not want to be seen as rewarding irresponsible behavior, for fear that it would encourage more of the same in the future. The decision to devalue the U.S. dollar, and thus ultimately the debt assets of lenders, must weigh heavily on the Federal Reserve and Chairman Bernanke. Yet I believe they realize that inflation-aided debt relief is the best monetary tool available to them to stimulate the economy, and I believe they have decided that, just as one cannot escape a Chinese finger trap without first yielding and not pulling tight right away, the best approach now is to give everyone a little more breathing room on their debts, so that the whole economic cycle can be stronger moving forward and more American workers can be saved from permanently dropping out of the labor force... And that will ultimately benefit everyone in the long run.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: The above article contains some economic reasoning that is intended to highlight what I see as a perhaps widely overlooked source of alpha due to likely QE3-induced inflation, in one form or the other, and to serve as a basis for further research on the part of investors, who should do their own due diligence before making the decision to buy or sell any security or any other asset. I am not recommending the specific purchase or sale of any security or asset here, but I do feel it would be wise to carefully consider the effects of a genuine economic recovery on the price of the precious metals.