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.
Emerging markets stocks. Investors may be fleeing U.S. stocks, but they're warming up to emerging markets stocks. Emerging markets stock funds have seen inflows of $21 billion from the first of the year through the end of October. The reason, Krosby says, is that economic news in these countries has been more positive. Countries like China and India came out of the global recession much stronger than their developed counterparts. The International Monetary Fund predicts that developing economies will expand at a rate of 7.1 percent in 2010 and 6.4 percent in 2011. Growth for developed countries is projected to be only 2.7 percent in 2010 and 2.2 percent in 2011. Just because these countries are growing at higher rates doesn't necessarily mean they will always be a good investment. "A market, regardless of the underlying growth, can actually become overvalued, and perhaps U.S. investors will start seeing the values in the U.S. equity market and realize that you need to diversify," Krosby says.
U.S. stocks. Given the slower-than-expected recovery in the United States, Krosby suggests investing in large, well-known U.S. companies that do a lot of business in emerging markets. About 35 percent of the sales of S&P 500 companies come from abroad, according to S&P international equity strategist Alec Young. Of that 35 percent, between 10 and 20 percent of the companies' sales comes from emerging markets. "What we've suggested to clients is that you can penetrate the growth in the emerging markets via many of the U.S. names in a broad swath of sectors," Krosby says. S&P recommends blue-chip, household names like Coca-Cola and Wal-Mart, both of which it rates a "strong-buy." Wal-Mart is in the midst of acquiring a South African company, and Young estimates that Coke makes about a quarter of its sales in emerging markets. S&P recommends allocating 45 percent of your total portfolio to U.S. stocks and 7 percent to emerging markets stocks.
Treasuries. The Fed's stated goal is to lower the yield of long-term treasury bonds, which means trouble for savers who depend on relatively safe investments like treasuries for income. It remains to be seen how successful the Fed will be in lowering yields after cutting the fed funds rate to virtually zero almost two years ago. Earlier this week, treasuries have experienced a bit of a sell-off, and their yields have spiked near 3 percent. Other savings rates still remain near historic lows. Investors should be cautious. "Does anyone believe in their heart that in the next 10 years, that a 10-year treasury at 2.6 percent is going to outperform stocks?" Satovsky says. "I don't think too many people believe that, but many people are structured as if they believe that." He stresses the value of diversification for investors who may have loaded up on low-risk assets during the downturn. Satovsky suggests that investors tilt their portfolios globally and diversify among corporate and government bonds.
Corporate bonds. The same bullish argument that can be made for U.S. stocks can be made for U.S. corporations that are issuing debt. "I think that right now because of the strong attention that people have put on U.S. treasuries—and the flight to safety at several points over the past couple of years—there is more upside on corporate fixed-income, especially on large, internationally diversified fixed-income," Torralba says. He recommends investing in the bonds of U.S. companies with large exposure to other markets, especially developing economies. A word of caution: High-yield debt has also performed extremely well lately. In 2009 alone, the average junk bond fund was up 47 percent. Year-to-date, the average junk bond fund has returned 13 percent. Krosby warns that the rally may have passed. She says investors should stick to higher-quality bonds because they aren't currently being compensated enough for taking the risks associated with investing in junk bonds, which are more likely to experience defaults than investment-grade bonds.
Foreign bonds. Some experts are concerned that the Fed's new round of easing could depress the value of the dollar. To hedge against that possibility, experts suggest allocating a small portion of your fixed-income portfolio to foreign bonds. "International debt is a good hedge against dollar depreciation," Satovsky says. He recommends that investors allocate between 2.5 and 10 percent of their portfolio to international debt. Don Quigley, co-manager of the Artio Total Return Bond, says he favors bonds and currencies from countries like Canada and Australia because the outlook for their economies is better than that for the United States. He says both countries have stronger banking systems, and he believes both will be raising interest rates sooner than the United States.