House View by the Chief Investment Office

Can markets survive without easy money? Spoiler: It's gonna be hard.

22 November | Tags: Monetary policy

Reading time: 4 minutes

Markets would struggle without easy money. But the era of easy money is not over, even if the US Federal Reserve raises interest rates and the European Central Bank (ECB) begins “tapering” its quantitative easing (QE) program in 2017.

Inflation is increasing. Consumer prices in both the US and Europe are climbing at their fastest pace in more than two years. Bond market quivers suggest that investors are beginning to cast a watchful eye on potential central bank responses: higher US interest rates and a slower pace of ECB QE. We expect US interest rates to rise to 1.00- 1.25% by the end of 2017, and for the ECB to reduce the pace of its bond buying.

Investors have clearly benefited from easy money in recent years. Can they survive without it?

The short answer is no – or at least not yet. Markets have historically performed relatively well in rate-hike cycles, but they tended to come at an earlier stage in the economic cycle, and against a backdrop of strong economic and robust corporate earnings growth. Today, many markets have already reached full valuations, and it seems unlikely that growth will return to what was once considered “normal.” Therefore, investors are right to be mindful of aggressive rate hikes. The “taper tantrum” of summer 2013, when bonds and equities fell in tandem, served as a warning of the kind of market environment investors should be fearful of.

That said, we do not believe that the coming year will bring the end of easy money. Indeed, real interest rates could in fact fall to the lowest level in two years as inflation increases more rapidly than nominal interest rates. In 2017, we expect inflation in the US to rise xxppts faster than rates, and xxppts more in the Eurozone. Like in the End Game, it comes down to a policy decision.

That said, we do not believe that the coming year will bring the end of easy money. Indeed, real interest rates could in fact fall to the lowest level in two years as inflation increases more rapidly than nominal interest rates. It comes down to a policy decision. Faced with a choice between aggressively hiking rates to combat a still unconfirmed inflation threat or maintaining loose policy to aid deleveraging and improve muted growth, central banks remain heavily incentivized to keep interest rates low. The policy orthodoxy remains focused on avoiding repeating the mistakes of the Great Depression, when monetary policy was tightened too soon."Central banks always try to avoid their last big mistake."

Fed Chair Janet Yellen has pointed out that she is comfortable with inflation that runs above target in order to encourage greater labor market participation. ECB President Mario Draghi “remains committed to preserving the very substantial degree of monetary easing,” suggesting that the ECB is still heavily predisposed to continue with considerable QE, even if the extent of it declines in 2017. And the Bank of Japan has only recently committed to capping the level of bond yields, a policy we expect it to maintain in 2017.

"Central banks always try to avoid their last big mistake."

- Milton Friedman

Against a backdrop of still-easy monetary policy, and a potential loosening in fiscal policy in the US under the new leadership, we overweight the US equity market. We also overweight US senior loans, which can benefit from investors’ hunt for yield in a negative real rate environment and provide some insulation against rising rates, thanks to their variable coupons. US inflation-protected bonds (TIPS) will also likely outperform nominal high grade bonds when inflation increases.

Investors should also consider allocations to less-correlated assets, such as hedge funds and private markets. History shows us that, even if interest rates remain low, equities and bonds can move in tandem when markets fear turning points in monetary policy, which raises portfolio volatility for diversified investors. Even if such episodes of higher volatility have typically lasted for only a few months, hedge funds can reduce vulnerability to this uncertainty. Meanwhile, private markets investments can help prevent ill-advised emotional responses to volatility that can permanently impair wealth.

In short

We expect the US Federal Reserve to raise interest rates and the European Central Bank to taper quantitative easing in 2017. But policy will remain accommodative as the focus stays on stimulating economic growth and employment. Against this backdrop we overweight US equities, US senior loans, and Treasury Inflation Protected Securities.

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The end game?

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