As extraordinarily accommodative monetary policies by three central banks begin to slow, halt and reverse, money managers are becoming increasingly cautious and preparing for the next — and unprecedented — phase in the global economic cycle.
The U.S. Federal Reserve is already on the path to monetary policy tightening, with interest rate hikes being undertaken and signaled for the coming months. The European Central Bank last week announced it would reduce the pace of asset purchases starting in January. And the Bank of England, grappling with the country's highest inflation rate in five years and a difficult negotiation over the country's exit from the European Union, has signaled a willingness to raise interest rates in the coming months.
A reversal in central bank policies "is pivotal to a degree; reduced official support for asset prices is clearly a concern," said Lucinda Downing, senior asset allocation analyst at Aon Hewitt Ltd., based in London. Ms. Downing said the moves by central banks add to a number of other concerns for markets, although "the mood in the market is still upbeat, even though central banks trimming balance sheets is ahead of us."
A number of money management executives highlighted the inflection point in monetary policy as a point of caution.
Part of the issue is that the extraordinary measures taken under quantitative easing across the globe "by definition means the unwinding is also unprecedented," said David Lafferty, Boston-based senior vice president, chief market strategist at Natixis Global Asset Management. "We are in uncharted territory here. We haven't fully assessed what the buying of assets has done. If we don't fully understand the ramifications of the purchases, it is difficult (to assess) the effects of unwinding. My head says this is going to be very slow, but my heart says it is hard to let the air out of a balloon very slowly."
Quantitative easing has led to "an extra $6 trillion sloshing about in the system. You don't have to pull a lot of it back to potentially do damage," Mr. Lafferty said.
While he isn't expecting a "calamity" in risk assets, investors must be prepared for it. "There will be a market reaction at some point, even if (it is) small. It is how that ripples through the system, the secondary effect, that becomes worrisome," Mr. Lafferty added. The firm is making use of options hedging as one way to prepare.
Hermes Investment Management's Fraser Lundie, co-head of credit in London, said investors might be entering a new phase in markets, with inflation expectations bottoming out and quantitative easing tapering.
That means "that negative relationship between government bonds and everything else is perhaps not quite as certain as it has been in the past," he said.