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What end of QE2 means for your investment portfolio

By Michael Preiss

26 July, 2011

On the back of US dollar it says:"In God We Trust". For many investors, however, US dollar weakness and quantitative easing (QE) meant:"In Gold We Trust."

Gold reached an all-time high of US$1,577(RM4,743) on May 2. Since then, gold has declined close to -5% and silver collapsed -22%, the biggest weekly decline since 1975.

The dilemma of QE is clear from the highly correlated rally in all "risk" assets, and the corresponding rapid decline in the value of the US dollar. The ringgit is trading at 13-year highs, the Singapore dollar is at an all-time high, oil is above US$110 per barrel, and gold and silver are in a parabolic surge.

Global financial markets increasingly seem to think that we had the best of both worlds for risk assets. If the US economy normalizes and grows again above par, equities and risk assets will rally. If the US economy falters, then equities will also rally as the market increasingly believes it could be saved by the next round of QE.

The US Federal Reserve's balance sheet expanded to a record size in May, as the central bank bought more bonds in an effort to support the economy. The purchase was part of its US$600 billion programme, dubbed QE2, aimed at stimulating investment and economic activity. The balance sheet - a broad gauge of Fed lending to the financial system - swelled to US$2.729 trillion. At these numbers, it seems that the Fed's flexibility to engage in further QE is increasingly limited, hence chairman Ben Bernanke's announcement that QE2 will end at the end of June. Investors beware.

QE describes a monetary policy used by central banks to increase the supply of money by increasing the excess reserves of the banking system. This policy is usually invoked when normal methods to control money supply have failed, such as the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero. A central bank implements QE by first crediting its own account with money it creates ex nihilo (out of nothing).

It is this creating money out of nothing that is potentially the problem and inflationary. While the US needs low rates, the emerging markets are experiencing a QE-led boom and potential bubble and higher inflation.

Western countries led by the US are growing below par and emerging markets are growing further above par, leading to more global imbalances are potential asset market bubbles in the future.

The US and other developed economies are expected to suffer from sluggish growth and potentially stagflation in the coming year because of budget cuts. Emerging markets and, in particular, frontier markets are expected to continue to boom.

Liquidity is focusing on scarce and expensive "growth" within global equity markets. The most expensive equities are seeing the greatest upward pressure on price. Too much money is chasing too few investable emerging market stocks. Barometers are Turkey, Indonesia, the Philippines, and frontier markets like Sri Lanka and Mongolia.

The World Bank recently lowered its outlook for growth next year in China and across East Asia, including Malaysia, urging officials in the region to curb inflation by raising interest rates and ward off asset bubbles to avoid a repeat of the Asian financial crisis.

As recently as April, the Fed was talking of exit strategies, with the market then looking towards upside surprises. Now, the Fed is officially saying that QE2 will end at the end of June, but many investors, professionals and retail investors alike do not seem to be aware of the significant longer-term implications for the asset markets.

The comments of a former Fed member, speaking at the IMF/World Bank meeting in Washington last year, summed up the Fed's thinking on QE2, "Monetary policy is the only game in town".

The only stimulus was coming from the Fed. Fiscal policy is completely paralysed by US partisan politics. Indeed, there is still a growing possibility of a US government shutdown, owing to having reached the legal debt ceiling. Should Congress not agree on raising the debt ceiling, the US will be in a technical default.

Given the politics, unemployment is figuring prominently in discussion about the US. Bernanke mentioned unemployment as a key early point in all his speeches. It was no surprise that the Fed engaged in QE2, but there are a lot of skeptics who question whether QE actually works!

Clearly it does, as unconventional monetary policy has allowed normality to return to most markets. Most stock markets around the world doubled from the March 2009 lows, and commodities and precious metals surged. The law of unintended consequences of QE2 led to a massive boom in commodities and higher headline inflation.

But therein lies the challenge, which still concern most policy markets in Washington as well as most central bankers around the world, namely that while additional QE might not provide much direct further boost to the economy, it would lead to higher commodity prices and inflation pressures.

There is real risk that current conditions could lead to a repeat of the commodity price-driven phony inflation scare world markets last experienced in 2007 and early 2008. Any repeat of such a market dislocation will likely lead to an overshoot in commodity prices, driven by financial investors in commodity indices and resource stocks, and ultimately result in a violent sell-off. That sell-off could likely be characterized by a violent rally in the US dollar as the carry trades are liquidated.

There is a growing risk that the foreign exchange market has overshot to the downside and risk/reward ratios continue to suggest to book partial profit on US dollar short positions. Economic data suggest that we are seeing a mid-cycle peak in global growth. As a result the US dollar is getting a temporary bid as risk is taken off the table.

Last month's sudden 25% collapse in silver and 12% fall in crude oil prices have changed the psychology and momentum of the EQ2-driven bull market and might signal lower commodity prices going forward. In line with this, Standard Chartered Bank's view is turning more cautious on commodities with a "neutral" rating for both the 3-month and 12-month view.

In the short term, a slowdown in US growth coupled with more rate hikes in Asia could lead to more risk aversion, a higher dollar and more headwinds in emerging market equities.

The current sell-off in commodities and stocks, in the bank's opinion, is a consolidation/pull-back and not a new bear market. Growing risks and 2H global economic slowdown and "softpatch" have led us to change our stance on global equities to "neutral" for both the 3-month and 12-month view. We were previously "overweight" for the 12-month view, but the end of QE2 and rising headwinds lead us to advocate a more "neutral" view.

Instead of mostly being a QE2 momentum-driven market, we feel it is increasingly becoming a more difficult stock pickers' market once QE2 ends.

Investors should adjust and rebalance their portfolios accordingly, and move into more defensive stocks and sectors. That said, markets are approaching an important juncture with the end of QE2 and the next few weeks could turn out to be critical for equity investors.

Michael Preiss serves as chief equity strategist

at Standard Chartered Bank

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