During the global financial crisis, the US Federal Reserve Bank (the Fed) initiated two rounds of support (known as quantitative easing) to help stimulate the US economy and avoid going back into recession. With the second round of quantitative easing (QE2) due to end in June 2011, we talk to our Head of Investment Markets Research, Matt Sherwood, about the potential impacts for markets and investors.

How have the two rounds of quantitative easing helped the US economy so far?

They have had two effects in the US – they have lowered interest rates and increased liquidity in the banking sector, creating two solutions to stimulate the economy to avoid going back into recession.

And the US economic recovery is now under way. Growth has picked up from its recessionary lows and the last piece of the puzzle is in place – the labour market is growing and we are starting to see recovery in the private sector. This doesn't only reflect the impact of quantitative easing but the fiscal situation, dynamics of the inventory cycle and the US dollar's depreciation against nearly all of its peers - the normal array of things.

QE2 is set to come to an end in June 2011. Do you believe the Fed will stop funding or begin a third round of quantitative easing?

The debate is now underway as to whether the US needs a third round of quantitative easing. Some members of the Fed believe it should stop while others, including the Chairman Ben Bernanke, believe it should continue with a further round.

Looking at the data, my impression is that there is no need for a third round because the recovery has arrived. It may not be as strong as the Fed would like – for example they may want to reduce unemployment faster – but in the scheme of things, the recovery is sustainable. So, I don't believe that QE3 is necessary. Also, reversing QE2 will be enough of a challenge, so I don't think the Fed would want to create a bigger problem with a third round that would eventually need reversing.

What do you think will be the main issues if QE2 stops in June?

There shouldn't be too many issues when it stops because all that will happen is that the Fed will stop buying US government and agency bonds.

However, problems will arise when the Fed starts to reverse QE2 by selling the bonds at some point. Just as buying bonds forces prices up and yields down, selling bonds will force prices down and yields to rise again. That means that buyers of those bonds will incur capital losses. The current US bond rate is at around 3.2%, so if that rose to 4.2% for example, investors would incur a capital loss of around 8%.

So, if QE2 is reversed, where will the government find buyers of assets which are going to depreciate by around 8%? There are really only three groups of potential buyers of these bonds, all with their own problems to address (see table 1), so it's likely that the Fed will be stuck with these assets for a considerable time.

Table 1: Who will buy US government bonds when QE2 is reversed?

Purchaser	Issues to address
US private sector (Banks)	Private sector investors would want to purchase US bonds when the US economy is subdued and the US Fed won’t reverse QE2 while this is happening. If the US economy is growing solidly, bond yields would rise and prompt capital losses for investors.
US Government	Governments need to be running surpluses to repurchase their own debt otherwise the private sector has to fund a larger government borrowing program each year. The US Congress seems incapable of agreeing with the Obama administration on a plan to reduce the deficit, let alone produce a surplus.
Foreign investors	All the risks for the private sector are evident for foreign investors in addition to the risk that the US dollar could continue to depreciate and produce larger capital losses in foreign currency terms. Meanwhile, Standard and Poor’s have placed US government debt on negative watch.

For the everyday investor in bonds (via managed funds), what will be the flow on effects of QE2 ending?

Managed funds that invest in US treasury bonds could incur capital losses which will flow on to investors in these funds. This is why some fund managers have been reducing exposure to US treasury bonds in the lead up to June 2011.

One way for bond investors to avoid the problem of capital loss would be to consider managed funds that invest in high grade corporate bonds. This type of bond provides a floating interest rate and is likely to do well as long as the economy continues to grow and as interest rates rise. At the moment, the US economy is solid and sustainable and the risk of corporate default is low, companies are less highly geared and as a result the risk/return characteristics of these bonds are much better than they were around three years ago. The Perpetual Diversified Income Fund is an ideal example of a managed fund that invests in high grade corporate bonds with floating interest rates which can benefit from this kind of environment.

How do you think the sharemarket will fare at the end of QE2?

At this point, it's difficult to say. Usually when economies start to recover and bond yields rise, the sharemarket continues to rally, but this is not always the case – rising bond yields have also been associated with share price losses.

So, although it's hard to know the answer at the moment, I think the US sharemarket will continue to rise because the outlook for earnings is consistently improving. However, I suspect that we are probably past the 'sweet spot' in the US and global sharemarkets where earnings growth is strong and interest rates are low. That doesn't mean that the upward trend won't continue, but other forces such as the depreciating US dollar, higher oil prices, rising US bond yields and policy tightenings in China and Europe could temper the rise.

In Australia over the next year, the sharemarket is likely to continue drifting sideways until earnings growth improves. During these times, it's the income producing stocks that are likely to serve investors well over time – in what is going to be a volatile time for markets and the Australian economy.

Can you provide a couple of examples of these types of stocks?

The banks such as Commonwealth Bank, Westpac and ANZ are stocks we like in our portfolios. They have good cashflow, their payout strategy is quite good and is shareholder focussed.

Orica is another that sells explosives to mining companies. It provides a way to get exposure to the resources boom without the volatility associated with commodity prices and mining itself. Orica is also a very diversified business – it also sells consumer products such as Yates gardening products.

What will be the impact on the Australian dollar and commodity prices?

I don't think the end or a reversal of QE2 will have a great impact on our dollar or commodity prices as there are other factors at play. When US bond yields rise, you would normally expect the US$ to rise against the A$ but that's not happening at the moment as I think the Fed is deliberately trying to depreciate the US$. While rising commodity prices have helped our currency rise as high as $1.10 in early May, I believe the main driver of our strong dollar at the moment is US$ weakness.

And if the US$ continues to depreciate, commodity prices will continue to rise and vice versa. That, combined with the emerging economies boom and a supply and demand imbalance means that the outlook for commodity prices remains positive. That's terrific for commodity exporters like Australia as it injects large amounts of national income into the Australian economy.

As a result of QE2 coming to an end, should investors be revising their strategy?

That depends on the individual investor of course. The end of QE2 is just one of a number of elements in a constantly changing environment, so investors need to look at the bigger picture. I certainly see investing as a long term game and I believe that certain rules never warrant changing. Some of those rules include buying quality investments, buying once and paying a good price.

If we're talking about bonds and fixed income, that's investing in securities with strong credit quality that represent good value considering the promised returns and potential risks. And for stocks it's buying quality companies with good financials, modest debt, consistent surplus cash flow and good operating models.

And finally, how does the Australian economic situation compare to the US?

Australia uses some similar policy tools to Europe and the US. During the global financial crisis, we cut interest rates, the government went into deficit but the Australian economy didn't go into recession, our banks remained profitable and we also had the effect of the mining boom. As we didn't need a quantitative easing program, we don't have any of the associated problems. The mining boom continues and the outlook for the Australian economy is very good. Our economy is in a different stage to the US – they are in the very early stages of recovery, while ours has been going on for around two years.
 
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