What To Make of the End of QE2

We are in the final third of the bull cycle. This is the 3rd year of the bull run, which started from March 2009 for most markets. If we look back at the previous bull run, which started from 2003 June, this will be somewhere in the region of 2nd half of 2005. Inflation will start to bite. In fact, inflation is very high in most emerging economies. In Singapore, inflation has hit 4.5%. In China, it is around 5%. In Brazil, around 6% and in Russia heading towards 7%. Developed countries' inflation is not low either. In the EU, it has reached 2.8%. In the UK, it reached 4.5%. Only in the US is inflation still bening at 1.2%.

This economic recovery cannot sustain if commodity prices remain so high. Commodities and equities must uncorrelate in order for stocks to sustain. If both rise together, sooner or later, divergence will occur. Usually, stocks will fall first before commodities. The culprit lies with speculators, especially in ETFs. For silver, ETF holdings of silver account for close to 50% of demand. Also to be blamed is the supply crunch and burgeoning demand from BRIC countries.

Fears are abound that the end of QE2 will bring about the demise of the stock market and hence the economy. However, the transmission mechanism of QE is not clear. While the Fed has pumped money back to the banking system, not a lot of it went into increased loans. I do admit that some of the sellers of US Treasuries could come from sovereign wealth funds or Asian central banks who are looking for opportunities to dump their misguided holdings in USTs. But the bulk of it did not flow into the real economy. Hence, QE2 may be a non-event. Especially in the light of the latest bouts of corrections in stocks, which started from the Japan earthquake back in March 2011.

There is also the fear of a restructuring of PIIGS bonds. This is certainly a possibility. If any of the PIIGS bonds are restructurered, the banking system of the EU, or even the world, may suffer huge losses and a concerted QE by affected economies may be warranted. If the PIIGS bonds are to be bailed out at maturity, some form of QE is required. Hence I also think this is a non event. However, the first scenario where PIIGS bonds are restructured and rescue from QE may require a meltdown of stocks first before a sharp rebound.

I believe that stocks will stay volatile until July 2011 before making huge advances in the second half of 2011. Valuations are still at mid levels. The yield curve is still very steep in the US and we are not expecting a recession in 2012. Commodities have already fallen by between 10 - 20%. I think the downside is rather limited.

Due to the structural scarcity of commodities, I will continue to add commodities into my portfolio, especially at corrected levels. I've calculated that when oil prices reach USD127/bbl, we will reach the end of our bull run. Back in 2007 Nov, oil price hit USD100/bbl and stocks started to fall. Oil went on to hit USD147/bbl in July 2008 before collapsing. I'm referring to WTI.  We almost reached USD115/bbl for WTI and Brent shot past USD128/bbl for several days. But Brent has fallen back to USD95 and Brent to USD108/bbl. We returned from the precipice. How do I arrive at the doomsday figure of USD127? It's the inflation adjusted price of USD100/bbl when stocks peaked.

With oil back at USD95, it feels like early back in 2006, when oil hit USD70/bbl. THe world can still tolerate oil at USD70/bbl but not for long.

I reckon things could get sour in late 2012 when stagflation hits most developed countries while emerging countries continue to look ok, although inflation will still be a problem.

I will continue to ramp up my allocation of commodities to 30%, with equities at 60%. But I will start to allocate around 10% to bonds. I'm starting to like bonds because many countries are quite late in the rate hike cycle, e.g. India, Australia, China. By end of the year, I will increase my bond allocation to 20%, with commodities at 40% and equities at 40%. You see, in a stagflationary situation, commodities will rise but equities fall. By early 2012, I'd be 10% into alternatives, 30% bonds, 40% commodties and only 20% in equities. By mid 2012, I'd be 20% into alternatives, 40% into bonds, 30% commodities and 10% equities.

This will still be a good year. Next year might be more challenging.