Easing into the winding down of QE

SHOULD WE WORRY ABOUT QE TAPERING?
The beginning of the end is |around the corner. This week |markets anticipate a major shift |in policy from the world’s most influential central bank. It is widely expected that the US Federal Reserve will cut the pace of its quantitative-easing programme by reducing the amount of its monthly bond purchases. The anticipation of this policy shift took global financial markets on a roller-coaster ride in the past few weeks.
WHAT IS QE, ANYWAY?
QE is a liquidity-injection programme designed to stimulate an economy by keeping interest rates low and flushing the financial system with excess liquidity, a combination that supports economic growth. A central bank implements QE by buying financial assets from commercial banks. As the central bank bids up the price of financial assets, interest rates are pushed lower. And as the central bank keeps buying, commercial banks will be flush with cash, and hence they have more to lend at lower interest rates.

WHAT HAVE BEEN THE EFFECTS OF QE?
The Fed’s QE programme has fuelled price increases for most asset classes around the world. Since it was first announced in late November 2008, 10-year US bond yields were pushed down from the average of around 5 per cent before the crisis to 1.6 per cent in April 2013. Since QE has played some part in “inflating” asset prices in the past five years, winding down the programme |could reverse at least part of the previous gains, and that is exactly what the markets have been worrying about.
WHAT STANDS TO LOSE AS QE WINDS DOWN?
Judging from the magnitude of the increase, stocks seem to be the most vulnerable asset class as QE winds down. But valuation suggests otherwise: Global stock prices have in fact gone up from a very cheap P/E [price-to-earnings] ratio of 9 times in November 2008 to 14 times at present, a level in line with the long-term average. Given a solid improvement in the economic fundamental of major economies, such as the US, Europe, Japan and China, the current P/E valuation is still reasonable in my view.
Bonds, on the other hand, are still expensive by historical standard. Compared with the normal pre-crisis level of 5 per cent, the current yield of 10-year US bonds of 2.8 per cent has nowhere to go but up as QE winds down. Bond prices will go down as yield goes up.

WHAT WOULD BE THE APPROPRIATE PORTFOLIO ADJUSTMENT?
First, hold on to stocks. Despite increased volatility, stocks with more preferable valuation are far better bets than bonds and should offer reasonable long-term returns as the world economy regains traction. Second, sell long-term bonds, as bond yields are poised to go up. And third, keep some cash and wait for stock-market volatility to present buying opportunities.

KOMSORN PRAKOBPHOL is a senior investment strategist at Tisco Economic Strategy Unit (ESU). He can be reached via www.tiscowealth.com or [email protected].