Investors had reason to be surprised by the Bank of Canada’s Jan. 21 interest rate cut. Not only was it not telegraphed beforehand, but most experts figured rates would climb this year, after the U.S. Federal Reserve raised its rates. But as anybody paying attention to what’s been going on overseas knows, the days of central banks operating in concert are gone.
While the Fed, the world’s most important central bank, ended its stimulus program last fall and is expected to finally start raising rates from their historic lows this year, the eurozone and Japan are just initiating quantitative easing (QE) programs. Meanwhile, Canada may cut its rate again. Switzerland’s central bank shocked markets by removing its currency’s peg to the euro. “It sure is fascinating,” says Eric Lascelles, chief economist at RBC Global Asset Management, especially after the relative harmony of different nations’ monetary policies following the Great Recession.
There is usually some variance in central bank policy, says Lascelles, but not to the extent that we’re seeing today. It’s happening because economic prospects vary so wildly from country to country. America is on a roll; Europe is not. Lascelles blames policy missteps. The U.S. did the right thing with its QE program, he explains. The European Central Bank should have acted earlier.
Mixed monetary policy makes asset allocation more challenging, especially as exchange rates fluctuate. When rates get cut, fixed income yields fall, causing bondholders to go looking for higher yields in other countries. That puts pressure on currencies, because bonds are mostly denominated in the local coinage. When international investors sell Canadian bonds, they’re effectively selling loonies too.
All of that increases market volatility, at both an index and a company level, says Paul Moroz, Mawer Investment Management’s deputy chief investment officer. For example, Procter & Gamble’s (NYSE: PG) second-quarter results were a complete miss, in large part because of currency issues. “It’s a U.S.-based company, but 60% of its dollars come from outside the country,” he says. “We’re seeing more of that.”
Investors can nonetheless take advantage of this divergence and the resulting volatility. Ben Homsy, a fixed income analyst at Leith Wheeler, expects a rate hike in the U.S. this year accompanied by dovish language, which he thinks will buoy the market. Unhedged investors in U.S. stocks will also get a boost if the loonie’s slide continues, he notes.
For value investors, the fall of the euro is turning up bargains, says Lascelles. The region has had so many problems that people are turned off. However, if European QE starts to work, then equities there could rebound quickly.
Lascelles is also keen on more interest rate–sensitive sectors here in Canada like utilities and REITs. “In a low-rate environment, you want that steady coupon, something that reliably pays that 3% or 4%,” he says. Blue-chip companies with more exposure to the U.S. are attractive too, says Moroz. A large company like Wells Fargo (NYSE: WFC) can ride out the ups and downs, and it also benefits from lower oil prices (people have more money in their accounts), an improving economy and an eventual interest rate hike.
Global monetary policy will eventually settle down. We just don’t know when. In the meantime, those who follow the money could be well-rewarded.
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