Finding balance amid worldwide QE slowdown

One of the most important economic trends to watch over the next year will be the slowing of quantitative easing (QE) by major central banks.

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The pullback of accommodative policies by the European Central Bank (ECB) and Bank of Japan (the BoJ), for example, will mark the first time in 10 years that asset-purchasing programs will be stopped or reversed, said Luc de la Durantaye, head of asset allocation and currency management at CIBC Asset Management, during a July 4 interview. These central banks are favouring tightening over QE.

The ECB and BoJ are still using QE, but the ECB announced in June that it will start to reduce its bond purchases in October, with the intention of winding up its QE after December. The BoJ reduced its purchases of bonds for the third time in June.

The U.S. Federal Reserve will also focus on tightening, by allowing up to $40 billion of its bond holdings to mature each month without replacing them, Bloomberg reported on July 9, noting the central bank intends to increase its tightening to $50 billion per month by the end of this year.

The Bank of Canada (BoC), which doesn’t use QE, announced its first rate hike in six months on July 11, citing a resilient economy despite trade uncertainty.

Read: Effects for clients as interest rates rise

“The [world’s] central banks are confident enough that the economic expansion is self-sustaining enough to remove accommodation,” said de la Durantaye, who manages the Renaissance Optimal Inflation Opportunities Portfolio. But that means economic activity is above potential, and we’re thus starting to see inflationary pressures in labour markets, particularly in Canada, he said.

Even though Canada added jobs in June, the unemployment rate still rose to 6% as more people searched for work. Further, Statistics Canada’s report found that average hourly wage growth, which is closely watched by the BoC, remained strong at 3.6%. The U.S. unemployment rate also rose in June, to 4% from 3.8%, and average hourly pay rose 2.7% from a year ago.

Read: How inflation data weigh on central banks

Tight labour markets in the global economy can pose a challenge for central banks, mainly in terms of finding balance between tightening too quickly or slowly, de la Durantaye explained. Policymakers must consider what’s appropriate for wage growth, he added, and know that “if [they] do quantitative tightening too soon, then you trigger, potentially, a recession. If you tighten too late, you trigger wage inflation.”

That’s why many central banks says they’re “very data-dependent,” said de la Durantaye. “This balancing act is going to be very difficult.”

Read: Banks raise prime rates after BoC announcement

Outlook for BoC

Given the global context and current domestic labour activity, what will the BoC do going forward?

De la Durantaye said another factor to watch is Canada’s real estate market, which “is in the process of correcting” with a decrease in home sales. The Canadian Real Estate Association (CREA) forecasted last month that home sales would fall 11% this year due to weaker sales in B.C. and Ontario. June home sales were 10.7% lower than a year ago, a five-year low for the month, though sales were up 4.1% from May.

Read: Why CREA cuts its 2018 home sales forecast

The real estate market must be monitored, especially since it’s still absorbing the full impact of new mortgage rules and other recent housing measures, de la Durantaye said.

In its July 11 rate announcement, the BoC said, “Recent data suggest housing markets are beginning to stabilize following a weak start to 2018.” Its accompanying Monetary Policy Report shows housing will contribute less to GDP between now and 2020, when it will drag on the economy.

“The sensitivity of consumption and housing to interest rates is estimated to be larger than in past cycles, given the elevated ratio of household debt to disposable income,” the report said.

The bank will “continue to be prudent in raising rates, going forward, and will lag the Federal Reserve,” de la Durantaye said.

Effects of trade tensions

Looking at equity markets, trade tensions have caused emerging markets to underperform—and that’s disappointing, said de la Durantaye.

Still, as of early July, most emerging markets (except for Turkey) were doing well, he said. Collectively, he found they have large foreign exchange reserves and that their valuations have improved in the last three to four months.

“We don’t think that we should give up on the outlook for emerging markets,” he said.

It’s actually U.S. multinational companies that are most at risk if a trade war intensifies, he warned. One reason is China may favour non-U.S. multinationals if their American trade relationship deteriorates.

“From that perspective, we would still hold onto our overweight [in] emerging markets and underweight [in] U.S. equities,” said de la Durantaye.

Read: What might cause trade tensions to ease

Finding portfolio balance

Overall, it’s time for capital preservation, and for finding balance in portfolios, said de la Durantaye. “We’re not recommending being overweight [in] equities at the expense of fixed income,” he added. “I think we need to maintain a balance with fixed income.”

For his portfolio, de la Durantaye is taking into account duration risk and market volatility, which he expects to rise over the summer. In a portfolio, “having some cash is a good thing,” he said.

He’s also keeping an eye on the rise in short-term interest rates and the potential for a subsequent flattening of the yield curve.

Read: What’s behind rising bond yields in Canada and U.S.

In terms of sectors worth holding, oil is interesting, said de la Durantaye, given “supply and demand from oil is holding prices relatively well.”

Also read:

Natural gas a natural pick for investors

Where oil prices are headed, and why

What to expect from the Fed in 2019

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