x Abu Dhabi, UAEThursday 20 July 2017

What happens when quantitative easing ends?

Just about the only thing quantitative easing by the US failed to do was restore faith in the UK economy.

The US poured Dh2.2 billion worth of Treasury bond purchases into the market, which kickstarted stocks and commodities, but pushed some emerging markets towards inflation. Analysts wonder, though, if the world's economies are any better off.Harvey Jones reports

Last autumn, stock markets were becalmed. The great recovery that began in March 2009 had foundered. Investors started worrying about a potential double dip.

Then, in November, the US Federal Reserve launched a second bout of quantitative easing, dubbed QE2, and whipped up an instant stock market storm.

The oil price soared. So did gold, silver, copper and commodities generally. Not to mention stock markets, yields on US Treasuries and US GDP. Inflation accelerated in emerging markets such as China and India. The Arab Spring blossomed. The dollar slumped.

Not all of this can be laid at the doors of QE2, but a hefty chunk of it can. It is amazing what US$600 million (Dh2.2 billion) worth of US Treasury bond purchases can do.

Just about the only thing QE2 failed to do was restore anybody's faith in the UK economy. They say miracles take longer.

On June 30, QE2 will finally reach dry dock. So what happens when the monetary magic ends?

To a degree, we've had a sneak preview. With an end to the sugar rush in sight, markets don't know what to do with themselves. One day they're on the rise, juiced up by another set of promising company results, the next they're down, depressed by Greece, US sovereign debt, Chinese inflation, the oil price, you name it.

QE2 was designed to keep interest rates low, encourage lending and stimulate economic growth, says Dan Dowding, the chief executive (Middle East and Asia) at IFAs Killik & Co in Dubai. "Did it succeed? Nobody can agree. Some claim the global economy is in a better state than it would have been, others say QE2 has fuelled inflation by artificially forcing up asset prices across the board."

China and India certainly didn't like QE2. All that hot money flowing around the global economy added to inflationary pressures in their economies, forcing them to hike interest rates.

Vladimir Putin, the prime minister of Russia, didn't like it either, accusing the Fed of inflating global asset bubbles and stirring up the currency wars.

Some even argue that QE2 gave birth to the Arab Spring by pumping up food prices to politically unsustainable levels. So presumably, Zine El Abidine Ben Ali, the former president of Tunisia, Hosni Mubarak, the former president of Egypt, and Muammar Qaddafi, the Libyan leader, didn't like it either.

The Fed, naturally, doesn't care what others think: it has the world's biggest economy to save.

Mr Dowding suggests the best way to work out what happens next is to look at what happened in March last year, when QE1 came to an end. "By the end of June, the S&P 500 had dropped an alarming 15 per cent," he says. "In August, when the Fed signalled a further dose of money printing, the index rallied."

Since QE2 was launched last November, the S&P 500 has grown 7.5 per cent. So can we expect another 15 per cent drop? Mr Dowding suggests markets may be tough enough to withstand it this time. "If the market takes the end of QE2 as a sign of confidence in the economy, the rally could continue. Central bank liquidity isn't the only factor that has driven prices higher. Stocks have rallied as corporate profits and margins have improved dramatically through cost-cutting and improved productivity."

If QE2 ignited under stock markets, it set commodity prices ablaze. Oil, food, gold, silver and industrial metals were on fire - until recently.

Commodities have just endured the sharpest sell-off in two years. On May 5, the oil price suffered its sharpest one-day fall on record, dropping $12 a barrel in a single day. In the same week, the price of silver plunged more than 28 per cent.

Can we expect further falls when QE2 ends for real? Maybe not. No sooner had commodity prices plunged than Goldman Sachs reversed its bearish position and urged investors to take advantage of the price falls, predicting that oil will surge to $130 a barrel in the next 12 months.

Some analysts even argue that we are in the early stages of a commodity super cycle that could last for decades, driven by demand from emerging giants, particularly China and India. If they're right, investors should take advantage of the current weakness.

A commodity fund such as First State Global Resources or JPM Natural Resources is a good core portfolio holding, says Tim Cockerill, the head of research at Ashcourt Rowan, the UK-based wealth manager. "Just make sure you invest for the long term. That means five or 10 years, and preferably longer. That should allow you to withstand any short-term volatility and see off the speculators."

Watch out, because commodities can dig a hole for the unwary. "Just look at silver, which has seen a dramatic price spike, followed by a sharp sell-off. The danger is that private investors got sucked in and lost heavily," Mr Cockerill says.

QE2 may steam back into port at the end of June, but US bond purchases will sail on regardless thanks to the Fed continuing to reinvest maturing assets, a process some have dubbed "QE2 Lite". It will also maintain its ultra-low interest rates of between zero per cent and 0.25 per cent.

Stock markets should also continue their voyage, says John Greenwood, the chief economist at Invesco, the UK-based fund manager. "We are still at the early stages of a recovery in the business cycle. Corporate earnings have rebounded strongly, especially in the US, and are likely to remain buoyant. The cycle is likely to continue expanding for two, three, four years or more at least."

The big unknown is whether the US will launch QE3 on an unsuspecting global economy. Although the Fed appears to have indicated an end to its virtual money printing blockbuster, like every wise Hollywood mogul, it has also left the way open for a sequel.

Again, opinions vary sharply. Mr Greenwood isn't anticipating QE3. "The signs are we aren't going to see another round of quantitative easing, although that may change if we see a significant weakening towards the end of this year or early 2012. But for the moment, it is off the table."

Spencer Lodge, the UAE regional managing director at PIC deVere, the financial brokerage, says the sequel may come sooner than we think. "It is sensible to assume QE3 will happen, given the US is $14.3 trillion in debt and at imminent risk of defaulting. At this stage, it seems the most obvious option to stabilise the economy."

Given the conflicting opinions, how should investors respond? "As always, it comes back to the mantra of having a diversified portfolio, to reduce your exposure to the many risks facing markets at the moment," Mr Lodge says.

The end of QE2 isn't the only worry afflicting global stock markets, says Rupert Robinson, the chief executive at the UK-based Schroders Private Banking. "Japan has fallen back into recession. Money tightening in China is fuelling fears of a hard landing. The spotlight is firmly back on the sovereign debt crisis in Europe. This is all casting shadows over investor confidence."

Everyone is worrying about inflation, but deflation remains a threat. "If US 10-year Treasury yields fall below 3 per cent, that would be a strong signal that the deflationary genie may have escaped the bottle."

Mr Robinson says investors should keep their powder dry for now and wait for buying opportunities when markets have corrected further. "The FTSE 100 at between 5,500 and 5,700 would be a good entry point. We still like Asian markets, but would advise clients to be patient. A good entry point for India would be 16,000 on the Bombay Stock Exchange and for China 2,500 on the Shanghai Composite A Index. These are more than 10 per cent below current levels."

Mr Robinson favours large-cap global blue-chip companies offering attractive dividend yields. "Given the uncertain social, economic and political environment, we also continue to recommend gold bullion."

QE2 isn't the end of the known world. Share prices won't fall off a cliff, says James Thomas, the regional director at Acuma Wealth Management in Dubai. "Markets can survive without the stimulus, but they will be a lot more volatile. Commodity prices won't crash either. Gold will remain a safe haven and oil will continue to be in demand."

Investors should resist any temptation to play the markets by selling all their shares and funds and sticking the money into cash. "It is impossible to predict the right time to exit the stock market and the right time to enter it again," Mr Thomas says. "It is far more rewarding to hang on for the longer term."

If the end of QE2 does sink markets, QE3 may be speedily dispatched to rescue them, securing an instant recovery.

Investors who withdraw from the market could be caught out if the Fed decides to paper over any fresh cracks in the US economy with another blitz of virtual dollars. "The Fed will want to keep the positive news flowing for a further few months and I expect a strategy will be announced in advance of the June 30 deadline," Mr Thomas says.

So how should investors respond? Don't sell. Buy on weakness, of which there is likely to be plenty over the coming months. Then hold for the long term.