Profit from QE3

As with many controversial issues, quantitative easing (QE) is widely misunderstood. Often simply referred to as 'money-printing', QE is compared unflatteringly with the policies that led to hyperinflation in Germany after World War One and in Zimbabwe more recently. In those instances, the authorities literally printed money and used it to meet their day-to-day expenses. That isn't how QE works, though. Instead, central banks buy up long-term government bonds, thereby lowering long-term interest rates, and leaving the banks and others who sold those bonds with cash to lend or invest elsewhere. Whether QE has worked is much less easy to say, however. The US and UK economies - where QE has been aggressively applied - have not yet achieved a strong and sustained recovery. Unemployment in America remains stubbornly high, while Britain has entered a double-dip recession in 2012. In Japan, where QE was pioneered more than a decade ago, economic growth remains enfeebled, while the problem of falling consumer prices persists.

Besides its failure to stimulate a lasting recovery, critics of QE vociferously denounce its negative effects. Despite a very slowly growing economy, the UK has suffered from uncomfortably high inflation. In late 2011, inflation on both the retail price index (RPI) and consumer price index (CPI) measures topped 5 per cent. This inflation has eaten into people's purchasing power, as wages increases have not kept pace with price rises. Retirees and other savers are meanwhile suffering negative real returns on their nest-eggs.

Despite these equivocal results, the authorities on both sides of the Atlantic are likely to keep faith with QE. The US and UK governments are highly indebted and need to borrow at the lowest rate possible, something that QE has achieved. The inflationary effects also shrink the real value of debts across the economy, which makes life easier for borrowers, albeit at the expense of savers and lenders. Having already done £325bn worth of QE since 2009, the Bank of England in July announced another £50bn of new money to come.

For all QE's failings - real and imagined - there is one area where its effects have been inarguably beneficial. Large-scale money-creation has led to a bonanza in risky assets. The fresh funds have been put to work in stocks, commodities, real estate and certain bonds, leading to significant gains. Investors who bought into these asset classes as each round of QE was beginning and who sold when it ended achieved seriously impressive results.

Sooner or later, America's Federal Reserve will surely join the Bank of England in announcing a further bout of QE. As to the precise timing, you can watch a discussion about that on our website. We also reckon there's a good chance that the European Central Bank (ECB) will adopt similar policies. In fact, we believe that it will have to if the single currency is to survive in its current form. When this happens, risky assets should shoot higher once more.

Following the first two instalments of QE in the US - and the ECB's long-term refinancing operations (LTRO) in early 2012 - we have a good idea of which assets are likely to benefit next time round. Our proposal is simple - to buy into these assets once more once it becomes obvious that QE is going to happen again.

QE and equities

What to buy for QE3

Equities boomed during the first two instalments of QE. Stocks from the developed world - represented by the MSCI World Index - went up 39 and 24 per cent respectively. Meanwhile, the combined performance of the MSCI Emerging Markets index was even better. In US dollar terms, they rose 102 and 19 per cent. Given that emerging markets have lagged behind their developed counterparts since late 2010, there's a decent chance they come back with a vengeance once QE3 begins.

While investing internationally has never been easier - you can buy funds that track both the MSCI World and Emerging Market indices on the London market - some investors may feel more comfortable staying local. No problem: UK shares - in the form of the FTSE 100 index - had a terrific run during US quantitative easing, but also during the ECB's LTRO.

Buying a FTSE 100 tracker would therefore be a simple and fairly effective way to try to profit from QE3. However, it would also be somewhat unimaginative. Better returns might well be earned by holding shares in medium-sized companies. The mid-capitalisation FTSE 250 index has beaten the large-capitalisation FTSE 100 index by a very wide margin during both QE1 and QE2, but also when the ECB launched its major liquidity pumping operations in early 2012.

Since mid-caps beat large-caps during these periods, you might imagine that small caps would do even better. But you'd be wrong: while the FTSE Small Cap index has outperformed the FTSE 100 index each time the major central banks went on the offensive, small caps did not do quite as well as the FTSE 250 index. So a FTSE 250 tracker offers obvious attractions once QE3 draws near.

A further consideration is which industries within the stock market are likeliest to do well. To determine this, I've looked for the sectors that have produced better returns than the UK stock market as a whole during QE1, QE2 and the ECB's LTRO. Seventeen sectors qualified here - see table below. Virtually all of the biggest winners from QE were cyclicals - industries with great sensitivity to the wider economy. These included the likes of auto & parts, industrial metals & mines and electronic & electrical equipment.

QE and sectors

By contrast, certain industries did notably poorly - and may well do so again in once the printing presses figuratively start to roll once more. These sectors are the polar opposite of the winners, being relatively economically insensitive. Shares in food producers, pharmaceuticals, supermarkets, mobile phone and gas, water & multiutilities therefore make obvious candidates for selling or avoiding next time round.

Commodities

One major effect of the Federal Reserve's QE programme has been to undermine the US dollar. During QE1 and QE2, the Dollar Index - which tracks the currency's performance against a basket of leading rivals - declined 7.1 and 9 per cent. A weaker dollar helps stimulate the US economy by making American exports more attractive. And the increased cost of importing goods from abroad helps to push up inflation – and therefore fight deflation.

When the US dollar weakens, commodities customarily strengthen. And that has certainly been the experience during QE. The Continuous Commodity Index - an equally-weighted basket run by Thomson Reuters - produced a total return of 31.2 and 29.7 per cent during QE1 and QE2 respectively. But certain categories of commodity did even better than this - and better indeed than equities.

While agricultural commodities were nothing to write home about during any of the three episodes I've looked at here, the action was red hot in energy, industrial metals and precious metals. Of the latter group, silver was a standout performer, galloping ahead by 69.4 and 88 per cent when the Fed was at work, but also gaining 7.5 per cent during the ECB's liquidity splurge - which was more than double what commodities as a whole did.

Since peaking at around $50 an ounce since April 2011 - as the end of QE came into sight - the semi-precious metal has dropped hard, shedding almost half of its value. By comparison, gold is only down by around one-fifth from its all-time high of 2011. So silver has enormous bounce-back potential as it is. Assuming it can repeat its earlier heroics - as seems likely to us - then a silver tracker makes an obvious way to play the upside. If you're feeling especially adventurous, you could even buy a leveraged product that will give you a multiple of silver's gains.

QE and commodities

Bonds

Because QE involves buying up government bonds in order to drive down long-term interest rates, you might well think that periods of QE would lead to higher bond prices. While US and UK 10-year bonds have trended much higher in price over the last four years, they've mainly gone down or sideways during the most active phases of QE. America's 10-year T-Note dropped 5.8 and 4.4 per cent during QE1 and QE2 and also lost 2.6 per cent during the ECB’s LTRO. The very long-term 30-year bond did dramatically worse.

Tactical investors should therefore consider lightening up on their holdings of US and UK government bonds when QE3 occurs - and put the money to better use in stocks and commodities. As the programme winds down, another bond-buying opportunity may well ensue.

QE, bonds and currencies