Investment markets have pretty much followed the script so far in 2011 Q2. Many of the risks that were hanging over the market at the beginning of April are still lingering. The situation in the Middle East is far from resolved and the U.S. economic outlook remains muddled at best. And some risks have risen to the next level. Leading among these is the deteriorating situation in Europe. Not only is the risk for default in places like Ireland and Portugal continuing to rise, but rumors even bubbled to the surface that Greece was threatening to leave the Euro Zone altogether. But just as before, investment markets have continued to largely ignore these ongoing risks so far in Q2. Instead, the focus remains almost exclusively on QE2, the Fed’s stimulus program that’s set to end on June 30.
Since QE2 is such a key driver for the markets, a few important questions are worth considering. First, what can we expect from investment markets in the final weeks before the end of QE2 on June 30? Second, how will investment markets react starting in early July once QE2 is finished? Finally, what is the likelihood that the Fed will return with another round of stimulus (QE3) at some point later in the year?
To answer the first two questions, it’s worthwhile to examine the market by asset class:
Stocks – The steady rise in stocks that started with the launch of QE2 last year is becoming replaced by swinging volatility as we approach the end of QE2. While stocks remain in an uptrend and reached a new post crisis high as recently as May 2, they are clearly losing steam. Short-term corrections are also becoming more frequent and violent, suggesting a shift to the downside for stocks may soon be on its way. Dissecting the stock market into its sector components is even more revealing. When QE2 was launched last August, the more cyclical sectors including industrials, retailers and commodities were the market leaders. But since the beginning of the second quarter, investors have fled these more economically sensitive areas in favor of more defensive sectors such as consumer staples, utilities and health care. This type of sector rotation from cyclical to defensive sectors is also common during the late stages of a stock rally. Portfolios benefitted from having a defensive stock emphasis heading into this shift, but many of these sectors are now starting to become a bit frothy in their own right. As a result, individual stock selection will become increasingly important in generating returns and protecting against risk as we head into the post QE2 summer months, particularly if the broader stock market moves lower as expected.
High Yield Corporate Bonds – This “stocks-lite” asset class continues to post consistently strong performance. High yield bonds have also avoided the swings of volatility that have been increasingly disrupting the stock market. As mentioned in the past, companies that make up the high yield bond category are building cash reserves and paying down debt, which is positive for the sustainability of these upside returns going forward. High yield bonds also remain reasonably valued and provide a +6% yield to go along with the steady price appreciation. While high yield bonds are likely to experience a pullback to some degree following the end of QE2, they represent an ideal way to still maintain stock-like exposure in portfolios while also protecting against downside risk in what could be a turbulent summer for stocks.
Investment Grade Corporate Bonds – Put simply, investment grade corporate bonds are among the best investment choices in a post QE2 environment. Most big companies are flush with cash and are ready to make the interest payments on their debts. In addition, if the economy slows as expected once QE2 ends, investors will likely flock to the high quality yield provided by investment grade corporate bonds. Although a bit overbought at the moment, investment grade corporate bonds valuations still remain reasonable, and the price performance of this asset class has also been consistently higher since the early days following the financial crisis, steadily rising both when QE is on and when QE is off.
Preferred Stocks – While this asset class should be generally avoided due to the near 90% weighting to financials, selected high yielding preferred stocks in the telecom and utilities sector may set up for attractive short-term investment opportunities in the coming months, particularly once we get into the post QE2 summer months.
Silver – The silver mania peaked and came to an end in Q2. Portfolio gains were locked in near the peak of the silver market and downside volatility has become extreme in the aftermath. While the thesis behind holding silver remains in tact, trading in this category has become toxic and remains overrun by speculators. As a result, it is best to avoid the silver trade going forward and look for more stable opportunities elsewhere.
Gold – Unlike silver, gold continues to represent an attractive investment opportunity. Chronic U.S. dollar weakening is a key driver behind the rising gold price, and this theme remains in tact with the U.S. government and the Fed still actively engaged in programs to promote money printing and currency debasement. Secondary themes including the threat of a double dip recession and geopolitical instability in Europe and the Middle East also remain supportive of gold. And the frequent talk in the press about gold being in a bubble is misguided, as trading activity in gold has instead been both rational and predictable for the last several years. If anything, stocks are far more “bubbly” than gold at this point. While short-term corrections like the pullback since the beginning of May should be expected along the way, the trend for gold remains very much in place. The key level to watch for gold as we move through the post QE2 summer is the 150-day moving average, which is now at $1,404 per ounce but will continue to rise as we move through the summer. As long as gold remains above its 150-day moving average – it is currently trading at $1,486 per ounce – the gold theme remains in tact. On the other hand, if gold were to eventually break below it’s 150-day moving average on a sustained basis, it may then be the time to lock in gains. Updates will follow along the way.
Treasuries – A variety of long-term risks face the U.S. Treasury market including massive fiscal deficits, declining demand from foreign lenders, ongoing political wrangling over raising the debt ceiling and the loss of a key buyer in the Fed once QE2 ends in June. Despite these risks, Treasuries still have the potential to be an attractive short-term investment theme for the post QE2 markets. The following are some key reasons. First, the economy may show signs of slowing down post QE2. Second, the situation in either Europe or the Middle East might take a turn for the worse. Third, the U.S. government may finally make progress in getting its fiscal house back in order. And finally, if the stock market falls into correction like it did after QE1, the trillions of QE2 dollars that poured into stocks will need to find a safe haven. All of these forces would be positive for Treasuries and would not be unprecedented. After all, many of these same forces helped drive Treasuries as the best performing asset class last summer – while stocks declined by over -15% from April 2010 to August 2010, long-term Treasuries gained +22%. And the +8% rally in these same long-term Treasuries since early April 2011 suggests some are anticipating more of the same for the coming summer. Any positions in Treasuries should be viewed as short-term holdings, however.
TIPS – Treasury Inflation Protected Securities (TIPS) perform particularly well when investors are concerned about inflation or deflation. Recent worries over inflation have driven TIPS prices +8% higher since February, but they are currently overbought following this strong run. The focus on inflation is likely to soon be replaced by the threat of a weakening economy, which is deflationary and would provide further support to TIPS. Despite these advantages, many of the same risks that overhang the Treasury market are also risks for TIPS. As a result, portfolio weightings to TIPS are likely to be reduced somewhat moving ahead.
Returning to the final question from the list above, it is very possible that the Fed may return later in the summer with talk about a new round of QE3 stimulus. I would assign odds at better than 50% at this point given persistent global geopolitical instabilities and the fact that the U.S. economic recovery remains sluggish. But the final result will depend on how the economy and markets perform in the aftermath of QE2. Regardless of what form the Fed might deliver stimulus to the market, it would be reasonable to expect that this would spark yet another artificial rally in stocks and other higher risk markets. How this all unfolds and the likelihood of QE3 will be the next key theme to watch as we move into the third quarter.
Bottom line – Investment markets are currently rotating in anticipation of the end of QE2. The stock rally has lost steam and has become more defensive. But many of the areas outside of stocks that are expected to perform well in a post QE2 environment have already begun to rally. Advanced positioning in these areas has proven beneficial so far, but close attention to markets will continue be critical in the coming weeks as volatility is expected to increase further as we move past the end of QE2. Fortunately, many investment categories remain set to perform well and provide opportunity in a post QE2 environment.