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Investment of the quarter: monetary policy

After five years where monetary policy for the major developed economies has been moving in the same direction, central banks have now started to diverge. The US started the process by announcing a withdrawal from quantitative easing in December last year. Mark Carney in the UK surprised markets in early June by calling an interest rate rise as soon as August this year. In the meantime, the European Central Bank (ECB) announced further monetary easing, while the Bank of Japan continues to pursue an aggressive quantitative easing strategy.

The monetary policy initiatives have been a key swing factor for equity and bond markets over the past 12 months. The original Federal Reserve announcement on the tapering of quantitative easing triggered the prolonged sell-off in emerging market bonds and equities, as investors reasoned that less systemic liquidity would stem flows into emerging markets.

The impact of subsequent announcements has been less profound. The immediate impact of the ECB announcement was to send peripheral European bond yields to new lows, while Mark Carney’s announcement caused a sharp but short-lived sell off in equity markets and a 0.5% rise in the 10-year government bond yield. Since the Federal Reserve announcement, it appears investors have been aware of the direction of travel, even if the timing remains opaque.

Perhaps the biggest question in the wake of the ECB announcement has been whether this suggests a buying opportunity in Europe. Managers such as Psigma’s chief investment officer Tom Becket have been taking exposure to peripheral European economies on the basis that they will be the likely beneficiaries of monetary easing. James Calder, head of research at City Asset Management, has also been raising his European weighting, suggesting that the ECB’s actions should speed economic recovery.

However, Henderson Global Investors multi-asset manager James de Bunsen remains cautious: “Austerity rhetoric has disappeared and peripheral debt and equity markets have rallied. I’m not confident that the underlying fundamentals are that good.” He believes the key may be the direction of the euro. It has already weakened considerably against the currencies of its key trading partners and may have further to go. This will produce a significant tailwind for corporate earnings. It will not be good for existing investors in continental European markets, but may provide opportunities for new investors to take advantage.

Taking bond exposure remains fraught with dangers. The smart money has been short on developed market government bonds for some time. De Bunsen, for example, says that across the group’s portfolios, they hold ‘virtually zero UK government and investment grade bonds’, on the grounds of their ‘asymmetric’ risk. Strategic bond investors have moved into more esoteric and less liquid parts of the bond market - asset-backed securities, floating rate notes - to protect themselves.

James Calder, head of research at City Asset Management, says: “Since it has become likely that rates would rise, we have confined our fixed income exposure to strategic and long/short bond funds, plus some floating rate exposure. We have also reduced the overall fixed income weighting in our portfolios as far as our mandates will allow.”

The unwinding of these extreme monetary policy measures is likely to disrupt markets for some time. However, within that disruption opportunities may lie. As monetary policy diverges, investors need to ensure they are on the right side of the trade. 

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