12 January 2018, written by Melanie Lee, Helena Powers
Tighter monetary policy is expected to be a hot topic this year.
After almost a decade of central banks buying financial assets in an attempt to lower long-term interest rates and boost economic growth and inflation, many now believe that the economy is strong enough to start withdrawing stimulus.
CIO expects the US Federal Reserve (Fed) to reduce the size of its balance sheet by around 20% and to increase interest rates twice. The European Central Bank (ECB) will halve its monthly buying of financial assets to EUR 30bn, and CIO believes the ECB will wind up its asset purchase program by the end of 2018. By the end of 2018, the Bank of Japan will likely be the only major central bank still providing monetary stimulus to the global economy. While significant, this tightening is likely to be limited in scale. Central bankers will remain responsive to economic data and continue to react to changing market conditions, and inflation is expected to remain contained.
Quantitative easing is not the only factor responsible for the low interest rates and bond yields in recent years; structural changes have also contributed and these are here to stay.
Among them are the ongoing retirement of the babyboomer generation, the increase of low-capital intensiveindustries and regulations that force pension and insurancefunds to accumulate long-term fixed income assets.
Tighter monetary policy will change market dynamics andinvestors should expect an increase in market volatility.CIO also mentions the possibility of bonds and equitiesrising and falling together, which would increase portfoliovolatility for investors diversified across these assets classes.Additionally, although bonds and equities might move intandem, correlations within equity markets could drop, ashigher interest rates lead investors to discriminate morestrictly between companies.
From an investment perspective, in a monetary tighteningscenario, the higher interest rates would benefit globalfinancials. Some potential implications to portfolios wouldinclude a need to diversify into alternatives – to help reducevolatility – and a focus on active management.