June 19 marked the 10-year anniversary of the start of the financial crisis in the U.S. One week later on June 27, as Italy finalized the recapitalization of Banca Monte dei Paschi di Siena SpA, global bond yields began to rise in a synchronized fashion by 25–50 basis points (see chart). Despite inflation levels that remained below stated targets, central banks committed themselves to pressing ahead with an exit from the emergency monetary policies of the crisis period. A milestone in the crisis may have been reached. We had been waiting for European bank recapitalizations since 2009!
Chart: Prices for U.S., Canada, and German government 2-year yields from 2005 to 2017
If economic expansions can hold their positive course, a tapering of central bank asset purchases and an increase of policy rates lie ahead for markets. This development reflects a reordering of policy priorities at central banks, namely the rise of financial stability as a central policy goal. A gradual removal of the emergency policy is good news generally, but it may force some adjustments onto asset markets that have been distorted by the years of low rates.
Leverage-sensitive markets like housing and auto should cool off. Excessively easy financial conditions have driven bubbles, which are introducing new economic and stability risks. Property in Switzerland, Canada, Australia, Sweden, Hong Kong, and the U.K. (and their related banking systems) may face some headwinds. Banking regulations at the Office of the Superintendent of Financial Institutions (OSFI) and the rules of the Canada Mortgage and Housing Corporation (CMHC) on mortgage qualifications are meant to address this overheating before it becomes a systemic risk. This is precisely the aim of the macro-prudential and monetary policy today.
Credit markets have been a destination for income investors during the period of depressed government yields. Corporate bond yields must rise to compensate holders for the higher risk-free rate. Some of the froth in credit may blow off, particularly from the leveraged participants.
The record low volatility level in debt and equity markets this summer reflected the easy financial conditions and would undoubtedly have induced more risk taking in markets if left unchecked.
As risk-free rates rise, the relative attractiveness of equities falls, unless their earnings and dividends are rising commensurately. Earnings yields today do compensate shareholders adequately, but the margin for error will be compressed.
The process of policy exit began in 2013 with Bernanke’s taper tantrum. Markets are better prepared for this and healthier today, but nonetheless should experience increased volatility. One year ago, in the aftermath of Brexit when monetary policy settings were set to maximum accommodation, we repositioned the funds toward risk assets on the belief that economic growth and earnings would recover. Recently, we trimmed the overweight in equities in the balanced funds to neutral for the first time since Brexit. Our outlook is still positive, but we want to reflect on this development and observe the consequences in economies and markets.
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This commentary may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.