What Quantitative Easing Does to Investors and the Man / Woman On the Street

Inflation and Interest Rates are Natural Regulators of Economic Cycles

Not too long in the distant past, when there was no such thing as quantitative easing, and when money could be exchanged into certain quantities of gold, inflation and interest rates often dictate economic cycles. Let’s say if today, aggregate demand is increasing faster than aggregate supply (Remember your “A” Level economics),  inflation will rise from 2% to 5%. Aggregate demand rises when people and businesses feel too optimistic and spend more than the available goods on offer. People would not put money in banks if the deposit rates were < 5%. Banks will then have to raise deposit rates > 5% to keep the deposits. In turn, banks will have to raise lending rates to a spread above the deposit rate. E.g. if deposit rates were 6%, lending rate will probably be between 7 – 8%. Businesses and consumers will borrow less because to make business sense, the investments will have to make > 8%. This in turn will lead to less investments and spending. The economy will then slow down because everybody spends less. Jobs will be lost. Aggregate demand will fall while supply remains constant. This causes price levels to drop.

A recession normally follows and inflation may fall to 1%. Suddenly, the deposit rate of 6% will look attractive and everybody will be flooding banks with money. Banks will lower deposit rates to 2% just to make sure that they are not flushed with too much cash because in a recession, there are few borrowers! In order to lend money out so as to earn interest income, banks will lower borrowing costs to say 3%. A lot of investment projects will suddenly make more business sense. The economy will expand because people will spend more, businesses will employ more. The economy reflates.

Without QE, there is an “invisible hand” that regulates the economic cycle, to ensure it neither gets too “hot” or too “cold”.

QE Distorts Capital Flows and Causes Bigger Bubbles In Future

But QE distorts the movement of capital. Even if inflation is at 5%, the central bank keeps interest rates unnaturally low, at say 1%. Banks could borrow from the central banks at 1% so there is no incentive to offer 6% for deposits. Banks will then lend money at 3% because every other bank has the same access to central bank’s cheap money. What happens to depositors? They will think that 1% deposit rate when inflation is at 5% is downright unreasonable. They will be forced to search for yields, from real estate, dividend paying stocks, bonds. This will force up the prices of risk assets to unreasonable levels, or form “bubbles”. Imagine when inflation is at 5%, you will not wish to buy properties unless the rental yield is 6% and the property cost $1m. But with QE, deposit rates are at 1%, so you don’t mind paying $3m for the same property as long as rental yield is 2%, or higher than FD. The same goes for bonds. Under normal circumstance, you’d require a 6% return from a bond of 5 years. Now, you’ll readily buy it at 3%. Businesses will invest in projects that give returns as low as 4%. Previously unprofitable projects will become profitable projects. The quest for raw materials to build the projects, or real estate will cause material prices to skyrocket. Workers on fixed salaries will clamor for pay rises that keeps up with inflation. In some countries, there could be riots due to low wages, food prices rising out of reach of the masses. The deadly combination of wage and raw material costs spiraling out of control will cause inflation will rise even higher to 10%.

The music stops when output cannot increase in line with inflation. What happens when inflation rises to 10% but GDP or output cannot increase > 10%? After all, there is only so many restaurant meals you can take, so many cars you can afford, especially when your wages are being eroded by inflation. Stagflation sets in. Ultimately, if central banks continue this dreaded path, the economy will plunge into a recession with high inflation. That is when money printing has to stop to contain inflation. That is when the “proverbial faecal matter hits the fan”.

What will happen to all the real estate that you chase until the yields drop as low as 2%? Once money printing stops, banks will not be able to borrow from central banks at 1%. Instead, interest rates will climb swiftly to 5%. Deposit rates will follow suit to rise to 5% and borrowing cost rise to 7%. Suddenly, that bond that you purchase at 3% is no longer attractive and everybody will dump it, causing bond prices to crash. Real estate prices will fall as well because the mortgage rate of 7% is much higher than the rental yield of 2%. To achieve a rental yield of 7%, prices will have to tumble by 71%.

We shudder to think of what will happen to risk assets / bonds that give pitiful returns, often below inflation rate. Today, Singapore’s real estate is giving only 3.2% of yield on average, lower than the inflation of 3.9%. bonds are giving on average 3% and may suddenly seem not like a “safe haven” when inflation flares.

Doomsday or Optimistic Scenario, Take Your Pick

This “doomsday scenario” could unravel quickly or slowly, depending on how responsive the central banks are to inflation. If they choose to ignore inflation slowly creeping up, they could be in for a rude shock when they wake up to find that prices are rising at 6% and they can’t contain it. If they take they foot off the pedal once every now and then when prices rise, it will probably cause a series of “shocks” to the economy. Long periods of weakness in the economy without the acute plunges in output.

The “optimists” will say, “this time it’s different and we can have growth without inflation. It is a wish that could come true if productivity rises faster than output. However, we still have to deal with the inflated assets like properties, bonds, some types of equities where yields are at 2 – 3%. Eventually the QE has to end and interest rates cannot stay at zero forever. What happens when reality sets in? At best we could see asset prices slowly trend downwards until they reach normal levels, i.e. if an issuer’s bond used to pay 4.5% per year over the last 20 years and it’s paying 3% now, it will revert to the mean. If a property pays 4% rental yield over 20 years and is giving 3% yield now, it will revert to the mean. All bubbles will eventually deflate. It is the mess that is left behind post bubble that causes nations to go through turmoils. Remember 1997 Asian Crisis, the Tech Bubble of 2000 and the Property Bubble in the US in 2006 – 08? Much wealth will be lost by the undiscerned.

Where do we then park our funds to prevent massive erosion to our wealth? We’ll cover this in the next post

Impact of QE3 on Risk Assets Part 2

Commodities

The biggest direct impact of QE3 will be on gold and silver. Here are the reasons:

1. There are nearly zero real options available to global policy makers. The world needs growth and is willing to go to extraordinary lengths to get it.

2. Macro-economic environment for gold is once again turning more positive and forecast prices to exceed USD2,000/oz in the 1H of 2013. Growth in supply of fiat currencies such as the USD will remain an important driver.

3. Gold vs fiat currency. Gold's value depends on large part on the degree of "badness" of bad money. This lends a certain art to the science of forecasting gold prices.

4. Gold as value: actions of central bankers continue to create disincentives for capital formation. Capital is an important resource, current monetary policy signals the opposite.

5. Investment flows into gold are changing significantly with the emerging world a growing source of demand. China is poised to overtake India as the world's largest consumer of gold jewellery. Emerging market central bankers are a key source of long-term gold demand.

Tune in for part 3.

Impact of QE on Risk Assets

In the course of my job, the first question that most relationship managers and clients ask me is, "what will the Federal Reserves' Quantitative Easing do to stocks and other investments?" Actually, it is not just the Fed that is printing money. Bank of Japan has just announced an increase in their bond purchases by JPY10 trillion or around USD130 billion. ECB has set up an ESM, and agreed to purchase sovereign bonds of Spain and Italy. The amount could be in EUR trillions although they vowed to sterilise it.

Let's look at the impact on various asset classes:

Real Estate

Singapore residential in general is one of the worst areas to invest. In descending order, the biggest bubble is

1) the OCR, especially if it's not near anyone of the industrial centres such as Jurong, Tampines, Paya Lebar or Woodlands / Sembawang. Rental yields hover around 3 - 4% and they are leaseholds. Imagine when these properties have 80 years left. Every year, the apartment will depreciate by 2%. Effectively, the net rental yield is between 1 - 2%.

2) RCR and CCR are areas where investment will have less downside when QE finally eases. The rental yields are the same as OCR's, but the rental demand is unlikely to fall as much as in OCR because they are nearer the CBD and nearer industrial / office sites like Paya Lebar.

For the foreseeable future, real estate prices will be pushed up by the flood of liquidity from central banks. But the downward forces will be: further government measures, such as raising the LTV to buy properties, supply coming in 2013 - 2015.

Look at the first evidence. Developers are already stuck with inventory that is higher than in 2007. It is an omnimous sign that developers may become increasingly desperate to clear their inventory.

 The vacancy rates shown below are still at record lows, indicating that there is still a shortage in supply. It means rental yields will stay at current levels for 2012, although 2013 will be interesting.

Bottom line: very little movement up or down until QE eases off. It will be a standoff between downward and upward forces. Rental yields could fall to 2% by 2015 while prices rise another 10 - 20%. However, once QE eases off, the property prices will fall. I am no longer bearish on Singapore properties for the next 3 years. But neither am I bullish. It's about the yield game and investors must be very disciplined in looking for properties that give very high yield. Do not be contented with just 3%, but look for 4 - 5% for residential, 5 - 6% for shops, 6 - 7% for industrial. Otherwise, I'd rather look overseas because yields are 5 - 7% in London, 10 - 15% in certain cities in the US.

Next up, my comments on other asset classes.

Getting Paid While You Wait... Strategy Works!

I've been saying that equity markets are cheap and that stocks probably won't crash much when valuations are this cheap. Many of the people that I advised did not believe this and continued to pile money into bonds and bond funds. The yield has fallen to 3 - 4% for SGD and yet people flock to the security of bonds without much capital upside.

Below is a chart of all the funds that I've been positive about.
1. Schroder Asian Income has been up 14.3% YTD.
2. Templeton Total Return SGD H up 9.5% YTD.
3. AllianceBernstein Global High Yield up 9.1% YTD.
4. Aberdeen Pacific Equity SGD up 8.1% YTD.
5. First State Dividend Advantage up 8.0% YTD.

Here you go...

Risk Assets Set to Rally Again... We Are At Half Time For This Rally

It is very difficult for stocks to crash when valuations range from almost Global Financial Crisis levels (e.g. Italy, Spain and China) to mid levels (e.g. S&P500, STI, etc). Any correction from now till end of 2012 will probably be no more than 20%.

AUDUSD and AUDSGD has turned up again. I was hoping for AUDUSD to fall to 1.00. For AUDSGD, I expected it to fall to 1.25. Both levels didn't occur before the turn around. AUDUSD turned around at 1.025 and it is now above 1.03. The same happened for AUDSGD. It stopped at around 1.27 and shot up.

Obviously the ECB announcement to bail out Spain and Italy, and China's S$180 billion stimulus has buoyed stock markets.

I do not think however, that the return risk ratio of changing from SGD to AUD is worthwhile because I am expecting a downside risk of 1.17 max. The extra 3 percentage point extra of yield that I get for investing in AUD Hedged bond funds cannot offset the potential 9 percent loss in currency. Why would AUDSGD or AUDUSD fall? There is a risk that the commodity down cycle is not over yet, at least for the next 6 - 9 months. If this be the case, RBA may cut rates two more times, which will of course add downward pressure on the AUD.

I strongly believe in the "Getting Paid While You Wait" investment philosophy. I'll stay invested in the following funds:
1. Schroder Asian Income Fund SGD 6% annual dividends, paid monthly.
2. First State Dividend Advantage SGD 4% annual dividends, paid quarterly.
3. AllianceBernstein Global High Yield SGD H, 6.5% annual dividends, paid monthly.
4. AllianceBernstein American Income Portfolio SGD H, 4.8% annual dividends, paid monthly.

Did Apple Rip Off Creative Tech's iPod Design? How Much Are Balconies Worth?

Apple Ripped Off Creative Technologies' iPod Design? Such Hypocricy

A posting on Guardian's article says,

"I would like to bring everyone's attention to another software company that got involved in litigation with Apple. Creative Technologies Singapore.

To put it simply, the ipod interface that got Apple out of the red into a multi-million to current multi-billion dollar business used portable meda player technology of Creative.

Creative sued Apple, and actually won. What happened in the end? Well, Apple paid Creative $USD100 million, but the damage was done. Apple had misused the patent to their own global advantage. The USD$100million was worth it for the global exposure the company had with the sales of its 1st generation I-pod and the billions of dollars of sales that came after. Now, Creative is back languishing in the shadows, and it even had to resort to be a component supplier for Apple to survive.

This is how Apple removes the competition. Ruthlessly.

http://news.cnet.com/Creative-sues-Apple-over-iPod-interface/2100-1047_3-6072488.html

http://www.guardian.co.uk/technology/blog/2006/aug/23/applepays100m

What are Balconies in Apartments Worth?

http://streeteasy.com/nyc/talk/discussion/2247-how-to-price-outdoor-space-deck-balcony-garden-and-basements

This came from a forum site presumably from the US.

"Outdoor space is calculated in different ways, depending on the type of space you're discussing. In my opinion, I believe that terraces you can look out on to from inside your unit are far more desirable than roof terraces you have to walk up a flight of stairs to access. I don't think there's a huge difference between a garden vs. a terrace, as that is purely a matter of choice - some people really like enclosed gardens where you dig down into the earth and plant large or very permanent greenery, while others love terraces higher up where your view (hopefully) is open sky and unobstructed.

In general a wrap terrace of decent square footage (read: useful - not four foot deep by 30 feet wide juliet balconies), perhaps 200 square feet minimum (something like 8 x 25 feet) is a good basic starter terrace. A medium sized terrace to me is something like 10 x 35 feet. Really generous terraces (over 500 square feet and well laid out) that wrap a unit are most desirable.

My calculations for a wrap terrace of this type are to take comp calculations of the price per interior square foot and muliply by a factor of .2 (20%) to .5 (50%) to arrive at the price per square foot the terrace is worth. Things like how high you are, the light, the views, the layout, how well planted and structured, the flow from inside to outside, the noise level, the quality of the unit and the building itself, location, privacy, etc. all contribute to being on the high end or low end of the 20%-50% multiplier."

20 - 50% square footage is about right. In Singapore, developers sell you 500 sq ft of internal space, with 50 sq ft of balcony and around 50 sq ft of bay windows / planter boxes and aircon ledges. The total area that they claim to sell you is 600 sq ft for S$1m. This works out to S$1,667 psf. However, planter boxes / aircon ledges are totally non livable areas. Balconies, if you don't have a view, probably counts for only 20% of the internal sq ft. If you have a totally blocked view, it probably counts for 50%. But if you have a pool view, but there is a block just 20 - 50m away, this is not a fantastic balcony and probably accounts for only 30% max of internal sq ft. 

Chances are, in Singapore, the balconies usually lead to some pool view if you're lucky, but in most cases, you look directly into your neighbour's living room. So I'll take 30% of 50 sq ft which is 15 sq ft. The actual livable area is only 500 + 15 = 515 sq ft . So how much are you really paying for the apartment in Singapore? S$1,942 psf. That's 16% higher than the agent's rough calculation. I often ask agents at show flats this question and they often claim they don't know or that the information is unavailable. When I bring a long a measuring tape, they usually stop me or told me that the show room is not "really" representative of the actual unit.

Here's another website that has an even stricter valuation of balconies.

http://www.seattlecondoreview.com/2006/06/post.html

"That said, most will probably agree that a balcony is considered a nice to have feature for a condo. As for the question on how much value it will add to the unit, I would put it around 1-3% (with some exceptions). A lot depends on:

• The size of the balcony

• Its general usefulness

If the balcony adds a materially big amount of square footage, buyers will obviously perceive more value than a smaller balcony. If the balcony is big but faces another building, the value is naturally less than a big balcony facing the Sound.

If there are two units with an equally good view and one of them comes with a balcony, the value can increase as much as 3% even at the high end. It will be hard to imagine someone paying for more than a 4% premium for a balcony.

In summary, the lowest value blaony is one that has no view and is small (this will yield a small 1% premium, if any).The highest value balcony is the one that is big and has a view which can possibly fetch as much as a 3-4% premium."

"Drink Less, Work More", Billionaire's Lesson... Time to Take Profit

http://sg.finance.yahoo.com/news/drink-less-more-billionaire-tells-152654355.html

Gina Rinehart was right when she said the non-rich should stop attacking the rich and go to work. "If you're jealous of those with more money, don't just sit there and complain. Do something to make more money yourself - spend less time drinking, or smoking and socializing and more time working." The comments were part of a treatise on what she sees as Australia's decline due to high taxes, high wages and over-regulation. Rinehart said taxes should fall, red tape should be cut, environmental rules relaxed and the minimum wage should be lowered. Her quotes are sure to escalate the already heated debate in the United States, Britain and Europe over class warfare, taxing the wealthy and "fair shares." When governments target the rich, she warns, they really hurt the middle and lower classes.

I think she has hit the nail in the head with the problems in the West. When UK's Nick Clegg said that he wanted to tax the rich, I knew that Britain could be heading the same way as Europe. French President Hollande also targeted the rich, as with most European countries. That is why more and more wealthy people are flocking to Singapore. The rich are mobile, they are welcomed in most countries. They also tend to be entrepreneurs who hire workers, spend more, which in turn help the economy.

As for investments, I do not think Fed Chairman's Ben Bernanke speech at Jackson Hole mattered much. The impact of each successive QE on stocks is diminishing. Ultimately, it is the real economy that will drive corporate profits. Interest rates are already near zero so the reflationary effects of a further QE may be minute. However, gold and silver are a different thing altogether. They tend to be poorly correlated to stocks, and move in lockstep with the balance sheets of major central banks.

When I look at the AUDUSD chart, it has broken below the key 1.04 support. The next support is at 1.00. It is a strong risk off indicator and with that trend line broken I have further hedged my portfolio and taken some profits off the table. Although the Dow rallied on 31 Aug after Bernanke's speech, the AUDUSD hardly rebounded as I expected. However, gold and silver did shoot up. It could mean that the stimulative effects of further balance sheet expansion is waning.

I do not think that a correction that follows will be more than 20%. Valuations are near 2008's level, especially those of China and European stocks.