Ending a decade of easing

As productivity grows, central banks will gradually slow stimulus. We don’t see cause for alarm. But some portfolios could become more volatile.

29 November 2017

This article is part of the UBS House View Year Ahead 2018, our yearly outlook on markets. You will find investment ideas and portfolio implications in the full report.

Investors are likely to hear a lot about tighter monetary policy in 2018. With global GDP expanding at its fastest pace in six years, many central bankers believe the economy is strong enough for them to start withdrawing stimulus. We expect the US Federal Reserve to reduce the size of its balance sheet by around 10% over the course of the year, and to increase interest rates twice. From January to September, the European Central Bank (ECB) will buy EUR 30bn of financial assets each month, a 50% reduction from the current EUR 60bn, and we see it winding up its asset purchase program by the end of the year.

By the end of 2018, in our view, the Bank of Japan (BoJ) will be the only major central bank providing monetary stimulus to the global economy. In aggregate, central banks will become net suppliers, rather than net demanders of financial assets for the first time since the start of the financial crisis.

A decade of easing

Since the financial crisis in 2007, the world's major central banks have injected more than USD 10 trillion into the global economy. In our animation, we compare inflows since 2007 and their impact on financial markets.

No cause for alarm

Although the move away from monetary easing marks a change, in our view, the scale of tightening is likely to be limited. The Fed's "quantitative tightening" process is going to reduce the size of its balance sheet only modestly, and global central bank balance sheets will still grow overall, thanks to stimulus from the ECB and BoJ. Should global growth or inflation slow again, or should financial markets experience a significant dislocation, central banks would respond with a move to an easier stance. And unlike in previous interest rate-hiking cycles, most central banks are not under pressure to slow inflation as it has remained stubbornly below targets.

Finally, structural factors beyond quantitative easing have helped suppress interest rates and bond yields in recent years, and are likely to continue doing so in 2018. Development of low-capital-intensity industries is dampening demand for investment. Ongoing retirement of the baby boomer generation is lowering prospective growth and reallocating savings toward fixed income. And regulation continues to force pension and insurance fund managers to stock up on long-term fixed income assets.

Stay prepared

Investor confidence in central bank intervention has helped keep volatility close to record lows in recent years. But even if, in our view, most central banks will retain an interventionist policy, their tighter stance could lead investors to become more nervous.

Historically, turning points in monetary policy have seen a rise in bond-equity correlations, a dynamic that would increase portfolio volatility for investors diversified across equities and bonds. And although equities and bonds might move in tandem, correlations within equity markets could drop, as higher interest rates lead investors to discriminate more strictly between companies.

With almost a decade of monetary easing drawing to a close in 2018, investors need to prepare for higher volatility, potentially higher correlations and stock dispersion.

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