Monetary policy divergence becoming unusually explicit

Monetary policy divergence — and the opportunities and risks it presents — is set to take center stage in conversations among global money managers in 2015, with expectations that divergence will accelerate.

Chatter will cover tightening and loosening of monetary policies, plummeting currency valuations and uncertainty over the timings of decisions by central banks calling the shots.

“It is the first time for many years that we have explicit monetary policy divergence,” said Bill Street, head of investments for Europe, the Middle East and Africa at State Street Global Advisors in London. “(In the past) we have had coordinated intervention by all (Group of 10) central banks, leading to a competitive depreciation of currencies. We are stepping away from that, which brings volatility in currency and in asset classes.”

“It is astonishing how divergent central banks have been,” said Eric Lascelles, chief economist at RBC Global Asset Management Inc. in Toronto. “It is interesting to contemplate that central banks diverging is (being done) with the intention of converging economic activity down the line.”

Executives at money managers said the U.S. and the U.K., after several years of quantitative easing, are set to tighten monetary policy at some point in 2015.

The European Central Bank has already begun to loosen fiscal policy and is depreciating its currency. The Bank of Japan is extending its quantitative and qualitative easing program.

“We expect monetary policies to diverge much more in the future than they have in the recent past,” said Jean-Luc Schneider, Paris-based deputy director, policy studies branch, economics department, at the Organization for Economic Co-operation and Development. “We expect the Fed to have to start tightening the policy at some point in 2015, whereas the Bank of Japan will continue its quantitative and qualitative easing, and will probably have to increase it — as (Bank of Japan Governor Haruhiko) Kuroda has announced he would be ready to do so. If this happens, as we hope and expect, there will be an obvious and strong divergence between policy stance in the U.S., and Europe and Japan.”

He said OECD officials are “not sure how markets will react, and (what may be) the implications for emerging markets in particular. ... We don't know which way the capital may be flowing. This may be mostly an issue for macro prudential policy, as managers of financial institutions like policy divergence that creates earning opportunities.”

For active managers at least, it is a case of everything to play for. Managers expect dispersion in market performance and growth due to policy divergence to create opportunities.

Monetary divergence between the U.S. and the euro area is echoed in the fixed-income markets. AXA Investment Managers said in its 2015 outlook that it expects U.S. Treasury yields to move toward 3%, while eurozone and Japan bond yields “are unlikely to rise significantly, being under the thumb of their respective central banks.”

But there are still opportunities within the bond market. “We remain overweight credit relative to government bonds,” said Mr. Lascelles. And when it comes to government bonds, RBC GAM is leaning toward second-tier government debt vs. sovereign debt.

“Stocks or bonds?” said Mr. Lascelles. “Our answer is still very clearly stocks. Bonds are still very expensive, so we are tilted toward stocks.”

Mr. Lascelles said in terms of the geographical opportunity, the U.S. market will continue to be strong but “probably not as strong as the last few years.” The Russell 3000 index returned 33.6% in 2013, and has gained 9.9% this year through Dec. 17.

The firm likes Europe and emerging markets. And despite recognition that there is “a fair bit of risk ... we find valuations fairly compelling and think possibly there is too much pessimism.” He said while there are political, currency and external debt risks, “we cannot deny that valuations are fairly attractive in those markets.”

At European equity specialist S.W. Mitchell Capital LLP, the prospect of monetary policy in Europe has got investors excited. “The potential for QE ... will be a major factor in 2015,” said Jamie Carter, a portfolio manager in London. “We are feeling a groundswell of support from our visits to Germany for QE — something that has been absent in recent years. QE has undisputedly lifted stock prices higher in the U.S. and we see the same outcome for Europe if we see a major stimulus increase.”

SSgA's Mr. Street warned, however, that with monetary policy divergence and uncertainty comes increased volatility, which should be taken into consideration when investing in equities in particular.

But Tim Edwards, director, index investment strategy at S&P Dow Jones Indices in London, said if his firm's analysis is correct, there might not actually be much opportunity for active managers, despite increased volatility and divergence.

“At the end of 2013, we noted the multidecade-low levels of dispersion and queried whether 2014 would be much of a stockpicker's market,” he said. “Now as we approach the end of 2014, it looks like in the U.S. at least that dispersion will be even lower than last year's.”

He said developed markets in general have low dispersion. “And the next big move, if there is a big move, is therefore likely to be an increase (in dispersion).” As Pensions & Investments went to press, Mr. Edwards said the dispersion number for December looked to be higher than recent months, “driven by the differentiated performance of the energy sector in particular. If you made the right call on energy this month, you'll have been rewarded handsomely.”

Emerging markets investors should be cautious too. “Tightening policy is a negative for emerging markets generally, especially from the (foreign exchange) and debt point of view,” said Gary Greenberg, lead portfolio manager and head of Hermes Emerging Markets at Hermes Fund Managers Ltd. in London. However, equities would benefit from a headwind as rates rise.

What is “spooking” emerging markets is the fear of deflation. “Chinese authorities are working hard to prevent a very serious run-down in the economy,” he said.

And there is general policy divergence to consider within emerging markets. A number of money managers during 2014 have highlighted the investment case in particular for India, citing political stability, financial reform and infrastructure investment as compelling cases for foreign investment.

India's BSE SENSEX index gained 28.2% year through Dec. 17, while Brazil's Bovespa, which was highlighted by managers as a less attractive investment, fell 6.6% over the same period.