September 13, 2012 1 Comment
On Thursday, the Federal Reserve announced that it would be taking aggressive steps to try and stimulate growth in the U.S. economy. In addition to the Operation Twist program already in place, the Fed will now also purchase $40 billion in Mortgage Backed Securities (MBS) each month in an open ended QE3 program that will remain ongoing until the Fed achieves what it believes to be sustainable improvement in employment. While I strongly disagree with the Fed’s decision, as the expected benefits associated with the program are limited in comparison to the potentially considerable costs both now and in the future, it is important to instead focus on the potential investment opportunities and risks associated with this latest program.
The following is a list of the notable expected winners and potential losers from the Fed’s QE3 program.
The biggest winner from QE3 is likely to be the precious metals space including Gold and Silver. A consequence of the Fed’s program is the potential for considerable weakness in the U.S. dollar as well as the potential for massive inflationary pressures in the future, and both Gold and Silver provide hard asset protection against such outcomes as a store of value and an alternative to fiat currencies. Conversely, if persistently aggressive money printing by the Fed and other global central banks eventually sparks a riot among global investors, investors will likely migrate toward the safety of Gold and Silver. Lastly, after an extended period of strong performance since the beginning of the financial crisis, Gold and Silver have trailed over the last year amid the limbo state of Operation Twist. As a result, Gold and Silver offer more attractive upside at current levels relative to other asset classes. Other precious metals categories that warrant consideration as a store of value for protection against both inflation and crisis include Platinum, Palladium and Diamonds.
Another major winner from QE3 is likely to be the general commodities space. This includes Industrial Metals such as Copper, Energy commodities such as Oil and various Agricultural commodities. This is due to the fact that Fed money printing results in currency weakness and inflationary pressures that encourage capital flows into these more price sensitive categories. And many of these commodities have room to the upside following sideways to downward sloping price performance since early 2011.
Stocks are also an expected winner from QE3, but the potential upside may not be as pronounced going forward. This is due to the fact that Stocks, particularly in the U.S., have traded higher over the last several months in anticipation of more monetary stimulus. And this has occurred despite an increasingly weakening global economy that would otherwise imply steadily declining stock prices, particularly at current elevated levels. As a result, a solid portion of the upside associated with QE3 may already be priced into stocks, constraining further gains going forward. But with financial institutions set to receive a $2-3 billion cash delivery from the Fed before the start of each trading day, this will at a minimum provide support for stock prices in the months ahead. And at this stage, the best upside opportunities likely reside in selected markets outside of the U.S. and selected sectors and industries within the U.S.
Other notable winners include Agency Mortgage Backed Securities (MBS) and U.S. Treasury Inflation Protected Securities (TIPS). Both of these categories tend to perform well whether the Fed is stimulating or not. But the fact that the Fed is focusing their latest program on MBS and that TIPS provide lower risk inflation protection add to the appeal of both of these categories.
The asset class most at risk from the Fed’s QE3 program is U.S. Treasuries. This is somewhat ironic given the fact that this is the category that the Fed often proclaims it is most often trying to support through its stimulus programs. But history has shown that when the Fed is engaging in balance sheet expanding monetary stimulus like QE3, U.S. Treasuries have fallen in price and yields have risen as investors migrate out of the safety of Treasuries and into other riskier asset classes. The key variable this time around is the simultaneous implementation of Operation Twist, which has shown the ability to keep Treasury yields low. At a minimum, this is a category that must be watched closely in the near-term for any sustained move to the downside.
In the long-run, these ongoing monetary stimulus programs from the Fed are likely to lead to a bad ending filled with unintended consequences and burst asset bubbles across numerous asset classes. But in the meantime, they present near-term opportunities that merit consideration. Of course, any such allocations must be accompanied by persistently close attention to the associated risks that could potentially emerge at any point along the way. Heading into the Fed’s announcement, portfolios were generally allocated 75% to directly benefit from a QE3 announcement including most of the categories listed above, 15% neutral and 10% to directly benefit if the Fed opted not to launch QE3 (U.S. Treasuries). Thus, portfolios were positioned to participate in the upside associated with the Fed’s announcement. Looking ahead, maintaining selected hedges for risk control remains prudent, but tactical shifts in portfolio allocations are also likely to now occur to capture expected opportunities from the Fed’s latest program going forward.
I will continue to provide updates along the way as economic, market and portfolio events continue to unfold. As always, if you have any questions or concerns, please contact me at any time.