House View by the Chief Investment Office

Global risk radar: The end of central bank easing Taking a step back

21 September 2017 | Tags: Risk

With several major central banks set to reduce monetary policy support, we elaborate on the potential market consequences of an end to unprecedented monetary easing. We believe an adverse market reaction is highly unlikely in the next six to 12 months.

After nearly a decade of unprecedented monetary stimulus, the global economy finally seems on a solid footing: unemployment rates are low and falling in many parts of the world, including the US (where the latest unemployment rate is at 4.4%, the lowest since 2001), the Eurozone (9.2%, lowest since 2009) and Japan (2.9%, lowest since 1994); global economic growth is sufficiently strong and broad-based; and financial assets are getting more expensive.

Historically, these conditions would be appropriate for central banks to start normalizing policy. In the US, where the economic cycle is arguably the most advanced, the Fed has already started to raise interest rates and may soon engage in "passive balance sheet reduction" – i.e. letting its accumulated bond holdings expire without reinvesting the proceeds. In the meantime, the Bank of Japan (BoJ) is scaling down its asset-purchase program for lack of new assets to buy, while the European Central Bank (ECB) is expected to reduce the pace of quantitative easing again this January.

Monetary policy of the major central banks over the last decade

Policy rates (in %), with forecasts

Source: Bloomberg, UBS, as of September 2017

  • Base scenario – no immediate danger for markets: As central banks reduce policy accommodation, interest rates should increase and demand for borrowing and investment is likely to decelerate. However, central banks will take great care not to disrupt the economy with their policy decisions. Furthermore, reducing policy support now should give central banks more flexibility to intervene in the future, should the need arise. In other words, even though returns in global markets may not be as stellar as they have been over the past years, moderation in monetary easing may ensure financial stability over the longer term, reassuring investors. The direct impact, if any, should be felt in safe fixed income investments.
  • Risk scenario – withdrawal of central bank support causes the end of this economic cycle: At some stage, a turning point could be reached in central bank tightening, where borrowing would become prohibitively expensive for businesses and households. This could lead to an economic slowdown and, importantly, a sizeable correction in financial markets (in a vernacular, central banks would "end this economic cycle"). Riskier and more lucrative asset classes such as equities would not be immune in this scenario, and investors would need to consider increasing their allocation to cash or protect the value of their portfolios in some other way.

Conclusion: Stay invested

CIO believes that positioning now for the end of this economic cycle may prove premature. Global central bank tightening is still in its nascent stages and interest rates remain low or negative in many parts of the world, while economic and corporate fundamentals remain strong. We favor holding a well-diversified portfolio with a preference for global equities over safe bonds and believe investors who shy away from investing for fear of a sharp market correction may face a sizeable opportunity cost and risk surrendering considerable financial gains in the coming months. Of course, one should monitor the global economy closely for the first signs of an impending correction.

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