QE III presents risks, opportunities

Investors should rethink strategies after Fed’s latest action

When the Fed announced QE III — or a third round of quantitative easing — earlier this year, the response in many quarters was underwhelming. After two previous rounds of quantitative easing had failed to get the economy moving, many investors responded to QE III with cynicism.

However, QE III actually should benefit the economy, and those benefits could be significant.

With its move to buy mortgage-backed securities, the Fed has committed to artificially depress interest rates until at least 2015. QE III should jump-start the housing market, which had already shown signs of recovery over the summer. It should also help banks rebuild their balance sheets and their profitability. There is a good chance that these factors will start a sort of chain reaction, giving a boost to consumer confidence and helping a broad spectrum of credit-dependent industries, particularly capital-intensive businesses.

But what does QE III mean for investors?

The short answer is that many investors should rethink their strategies. Investors who turned away from equities and toward bonds during the aftermath of the financial collapse need to consider reducing their long-dated fixed-income securities.

Over the last 12 months, as investors withdrew $126 billion from U.S. stock funds, they purchased $288 billion in bond funds. And they did this just as interest rates were hitting all-time lows.

Put another way, bond buyers were paying the highest price for bonds, ever — and ever is a very long time. Ironically, as investors have tried to find a safe haven from the storm by purchasing the perceived safety of fixed income, they have helped create the next bubble.

In pursuing QE III, the Fed really has two goals in sight.

The first is widely understood: the Fed is trying to keep interest rates as low as possible.

By purchasing bonds in the open market and lending money to banks, essentially without interest, the Fed has had a goal to lower the “cost” of money and encourage banks to lend more to businesses to finance hiring and capital expansion.

So far, the introduction of cheap money into the economy has had limited success — most of that money is sitting unused on the sidelines while businesses seek assurances that a genuine economic recovery is underway.

The second goal is to inflate asset prices and move investors away from fixed-income securities and into real estate, real assets and equities. The increase in asset prices should produce a “wealth affect” — some of those inflated assets will be sold and the funds used to purchase goods and services, supporting economic growth.

The risk of bonds

Low interest rates result in lower bond yields, which make them less attractive as investments. The logical trend would be for money to move from bonds to other higher-yielding assets or be used to buy consumer goods.

Currently, bonds are more than just a less attractive investment option. Their price is being blatantly manipulated to extreme levels by the Federal Reserve. Since 2008, billions of dollars have flowed toward bonds. The massive migration of money to bonds when interest rates are so low has made them much more expensive to investors than other types of investment — and ultimately, much riskier than is understood.

Eventually, as the economy is fueled by ultra-low rates and the recovery becomes more robust, interest rates will jump and the value of bonds that were purchased at historically low rates will tumble. It’s not a question of if this bubble will burst, but when.

Where should investors turn? The first place is high-quality, dividend-paying stocks. Even though we have seen a lot of turbulence in the stock market over the past five years, short-term losses have been more than made up by the upward trend of corporate profits.

In spite of continued jitteriness on the part of many investors, the fact remains that profits have exceeded their 2007 peak and the value of the Dow is roughly double what it was at its nadir in 2009.

Diversification is generally a key to successful investing, and this has never been truer than it is today. One way to diversify is to also look overseas for good investment opportunities. Global or international funds provide access to overseas investments, while permitting investors to diversify their holdings in those investments.

For investors who are committed to investing at least some of their assets in bonds, overseas bonds can provide better value, since interest rates aren’t quite as low in many other parts of the world.

Finally, investments in real assets, particularly those that produce a cash return, are attractive today. For instance, by investing in commercial real estate, investors can obtain a tangible asset while also earning lease fees from companies to whom they are renting space.

Likewise, there are a number of different types of infrastructure, such as gas pipelines or wind turbines, that offer are unique and attractive, because they can offer both short-term cash flow and long-term capital gains.

For investors who are heavily invested in fixed-income securities, the Fed’s actions should raise red flags. In recent years the Fed has been aggressively trying to push investors away from bonds and into other investments. This trend is continuing with the QE III, and investors would be wise to pay attention.

Marshall Rowe, president and chief investment officer at Harvest Capital in Concord, can be reached at mrowe@harvestcap.com.