Eye on the economy:
The end of quantitative easing will bring more volatile market
In the second of a two- part series, Clément Gignac, senior vice- president and chief economist, Industrial Alliance Insurance and Financial Services Inc., looks at how the end of quantitative easing policies in the United States could impact markets in the months to come.
Q Overall, what will the end of quantitative easing bring?
A Looking ahead for the capital markets in 2015, investors should be prepared for much more volatility. That will be the most obvious fallout from the end of quantitative easing in the U. S. The other expectation is U. S. dollar appreciation. That has already started to happen since mid- year as a result of divergence in monetary policies between the U. S., which is thinking about raising interest
rates, and Japan and Europe, where quantitative easing programs are taking shape. In such an environment, the Canadian dollar should also suffer, but in a lesser way. Q What about interest rates?
A We still expect an increase in long- term interest rates. These have been exceptionally low for a number of years as part of central banks’ strategy to target inflation and drive economic recovery. By 2017 we expect to see more normal rates for federal funds in the range of 3.7% to 4% for 10- year bond yields in the U. S. and 3.5% in Canada. And what most investors do not realize is that higher rates mean that bond prices are going down, which means that this could generate a negative return on your investment.
Q What can investors do to combat that?
A There’s no need to panic and sell your bond holdings at a loss. The key is to diversify your asset mix and invest in shorter duration bonds. Diversification could also mean increasing corporate and international bond holdings.
Q What role will the oil price decline play?
A The decline in oil prices has no direct relationship to the ending of quantitative easing. But there is an indirect link, in that the end of quantitative easing leads to a stronger U. S. dollar, which in turn pushes commodity prices down. Q What about the equity side? A Some very interesting things have happened there. In the last few years, the U. S. stock market performed much better than other stock markets overseas. Now with the end of quantitative easing in the U. S. – and the fact that Japan and Europe will continue their QE policies – it might make sense to reduce U. S. stock exposure and consider more overseas holdings. This makes sense because the dollar appreciation adversely affects the competitive position of U. S. companies, since a lot of their earnings come from overseas investments. At the same time, Japanese and Eurozone companies will benefit. If you combine everything — valuations, liquidity, and the prospects of earnings — the environment is changing to favouring diversification with more overseas stocks. Overall, it’s not a matter of being pessimistic about U. S. stocks. It’s more one of not being overly optimistic about them. Or overly pessimistic about European equities for that matter.