The Federal Reserve's second round of quantitative easing, commonly referred to as QE2, has sparked huge debate on topics ranging from the future of the dollar to the threat of a bond or commodity bubble. The Fed will pump another $600 billion into the long-term treasury bond market, which is supposed to spur lending and kick-start economic activity. Experts say the announcement has also raised inflation expectations globally. There are concerns that a huge buyer in the bond market, like the Fed, could have huge implications for the way the markets perform over the coming months, and there are even worries that the Fed's move could have unintended consequences. Investors should take note.
Investors have taken refuge in the bond market for quite some time. From the start of this year through the end of October, mutual fund investors have pumped almost $250 billion into U.S. bond funds, and pulled about $65 billion out of U.S. stock funds, according to Morningstar. Even as the stock market has rallied somewhat, investors seem to remain skittish about U.S. stocks. "They don't realize their risk is inflation," says Jonathan Satovsky, CEO and chairman of Satovsky Asset Management. "Their purchasing power and their quality of life are being attacked right now, and it's this silent killer of inflation that they have to be aware of." Not being exposed to any risk is actually a risk in itself, he says.
Some experts say that by initiating another round of asset purchases, the Fed is coaxing investors into riskier asset classes, like stocks. "Part of the goal, believe it or not, of buying the treasury bonds is to push the yield so low so that ultimately people move into stocks, which is considered a riskier asset class, and create the wealth effect that perhaps ignites a more sustainable recovery," says Quincy Krosby, chief market strategist for Prudential Financial. She says this could create bubbles in asset classes like commodities, which have recently experienced huge run-ups.
All of this analysis should be viewed through the lens of each investor's long-term asset allocation plan. It's important to understand that QE2 is designed to influence the markets in the short-term, so making major changes to your portfolio may not be a smart move. "In terms of long-term strategic asset allocation, QE2 is a non-event," says Francisco Torralba, economist at Ibbotson Associates, a Morningstar company. "QE2 is not designed to affect returns or risk in the very long run. It's mostly meant to have a short-term effect on expected inflation and hopefully growth as well."
As you're deciding how to position your portfolio for the coming changes in the global financial markets, here is some food for thought about how a handful of popular asset classes have performed and where they could potentially be headed. Some areas of the market have been shunned by investors, while others have seen an influx of investment in recent months. Generally, experts say the best way to approach this market is to follow time-tested strategies like dollar-cost averaging as opposed to investing lump sums. Here are six sectors to watch:
Commodities. Precious metals like silver and gold have benefited from global uncertainty and what some experts call a potential "currency war." Some emerging markets countries like China claim that the United States is purposely trying to devalue its currency through quantitative easing, while the United States contends that China keeps the value of its currency, the yuan, artificially low. Weak currencies and low interest rates have sent many investors into hard assets like gold and silver. Often referred to as the "poor man's gold" because it's generally cheaper to buy, silver has outperformed the yellow metal so far this year. The SPDR GLD Shares ETF (GLD) is up 22 percent year-to-date, while iShares Silver Trust ETF (SLV) has returned 51 percent. Other industrial metals have benefited from booming industries in emerging markets. Platinum and palladium, both of which are used in the production of cars, have also performed well lately. ETFS Physical Palladium Shares ETF (PALL) and ETFS Physical Platinum Shares ETF (PPLT) were both launched earlier this year. Since inception, PALL is up 56 percent and PPLT has returned 6 percent. It may be tempting to buy into the commodities rally now, but Torralba says he sees a bubble in both gold and silver. "It's really difficult to pinpoint the end of a bubble, but at some point it will fall—potentially very fast and sharply," he says.