Portfolio diversification helps to protect against monetary policy missteps
Until monetary authorities provide clear guidance about future policy, volatility risks highlight the need for asset diversification in long-term investment portfolios.
- Sustained higher inflation in advanced and emerging economies has placed monetary authorities under pressure to hike interest rates and tighten policy.
- As global central banks actively try to stabilise economies, the potential for policy error creates risks for financial markets.
- Until monetary authorities provide clear guidance about future policy, volatility risks highlight the need for asset diversification in long-term investment portfolios.
Rising inflation and interest rate hikes
In January 2022, the South African Reserve Bank’s (SARB) Monetary Policy Committee (MPC) continued the interest rate hiking cycle, increasing the repo rate by another 25 bps to 4%. Although the decision was not unanimous, with four members of the MPC preferring an increase in rates and one voting for rates to remain unchanged, it has become clearer that the MPC intends to increase interest rates from historically low levels.
The MPC is responding both to upside risks to South African inflation and the increased risk of monetary policy tightening by central banks in developed markets. Importantly, the MPC did not discuss hiking rates by 50 bps, showing that it is unlikely to be aggressive.
SA is not unique in experiencing rising inflation and the decision to hike interest rates. According to the International Monetary Fund (IMF), the average rate of consumer inflation in emerging markets was measured at 5.8% year-on-year in December 2021, up from a mere 4.4% a year ago. Equally, consumer inflation in developed markets rose to 3.5% year-on-year in December 2021, up from only 0.5% a year ago.
This sharp increase in world inflation is partly related to ongoing global supply disruptions as well as to a sharply higher oil price, strong demand for goods, rising wages, and elevated commodity prices.
In response, many central banks have increased interest rates since 2021. In fact, a total of 32 countries (mostly emerging markets) have increased interest rates since 2021. Of those countries, 22 have hiked rates in the first two months of 2022, including the UK, South Korea, Brazil, Argentina, Poland, Chile and SA.
Critically, despite the monetary policy adjustments under way globally, there is increased potential for policy errors by central banks that would affect financial markets this year. In fact, in making its decision, the SARB indicated that “it is uncertain how far the international normalisation of monetary policy will go, as well as the exact timing. And this uncertainty continues to cause financial market turmoil and capital flow volatility”.
Emerging markets feel pressure of advanced economies’ monetary policy decisions
Given this uncertainty, the SARB (and many other emerging market central banks) is keeping a close eye on actions by central banks in advanced economies, particularly the US Federal Reserve (Fed). An element of the SARB’s decision to hike rates was influenced by global rate hiking trends.
In its recent meeting, the US Federal Open Market Committee (FOMC) decided to leave the Federal Funds target interest rate unchanged at a range of 0% to 0.25%, and also decided to leave the pace of QE tapering unchanged. This means that the Fed’s asset purchases will stop in early March 2022.
Importantly, the Fed indicated that “with inflation well above 2% and a strong labour market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.” This could be interpreted as the Fed signalling that the first rate hike will occur at the FOMC meeting in March 2022.
Similar moves have been seen in Europe. In its latest meeting, the European Central Bank (ECB) decided to keep its key interest rates unchanged, despite record rises in inflation. Instead, the ECB recommitted to its decision that its €1.85 trillion Pandemic Emergency Purchase Programme would reduce net purchases and stop them in March 2022. In contrast, the Bank of England (BoE) has been relatively more aggressive, increasing its policy rate for two consecutive meetings, with more increases expected in 2022. In addition, the BoE’s MPC voted not to reinvest any of the £875 billion of government bonds it has bought under quantitative easing programmes when they mature.
The evolution of monetary policy tightening by central banks in developed markets, including the Fed and the ECB, will certainly put pressure on emerging market currencies, including the rand. Growing expectations of tightening by the Fed has contributed to most emerging market central banks adopting hawkish tones this year, as they seek to maintain attractive interest rate differentials.
Current outlook for global monetary policy
Given the higher inflation trajectory, the bias in global interest rates is to the upside, even as central banks try to avoid any undue tightening of monetary policy. It now seems likely that the Fed will hike rates five times in 2022 and by 25 bps on each occasion. In terms of the start of quantitative tightening, the Fed indicated that reducing the size of its balance sheet will commence only after the process of increasing the target range for the Federal Funds rate has begun.
Critically, while the members of the FOMC agreed to start to hike rates in March 2022, Chairman Jerome Powell made it clear that the pace of unwinding accommodative monetary policy will be steady rather than aggressive.
It also now seems likely that the ECB will embark on its own rate hiking cycle in 2022, given recent higher-than-expected inflation data. However, ECB President Christine Lagarde emphasised that the ECB would stick to the “sequence” it had already announced of only raising rates after it stopped net bond purchases, adding that the council would follow a gradual approach to tightening.
For SA, the SARB is likely to continue to hike rates during 2022, and we now expect a further three rate hikes this year (of 25 bps each), taking the repo rate up to at least 4.75% by year-end.
Risks facing financial markets given current monetary policy adjustments
Unfortunately, the monetary policy adjustments that are under way have introduced two equally concerning risks, particularly from a financial markets perspective.
Firstly, it has become evident that many central banks, including the Fed, have been hesitant to tighten monetary policy, arguing that the current acceleration in inflation is “transitory”. If this approach persists, there is a real risk that the major central banks could increase interest rates far too slowly, allowing inflation to take hold more fully. This would undermine economic activity, causing the already-fragile global economic recovery to slow further.
Under these circumstances, with higher consumer inflation becoming more entrenched, central banks will eventually be forced to be more aggressive in their monetary policy tightening, which would place strain on a number of financial assets, including stocks and bonds.
Unfortunately, the opposite risk is also prevalent. In other words, it is possible that central banks could overreact to the current high rate of inflation and decide to tighten monetary policy very aggressively to prevent a more persistent increase in consumer prices. This would risk pushing economies back into recession.
All things being equal, undue monetary policy tightening would trigger a real interest rate adjustment and lead to a higher discount rate, resulting in lower stock prices. Added to this is the risk that a more aggressive tightening of monetary policy will lead to stronger capital flow reversals from riskier assets such as emerging market debt.
Given these risks, long-term investors should remember the principle of asset diversification to manage the risk to certain asset prices caused by a substantial policy error by the major central banks. This should remain front of mind at least until it becomes evident that central banks can adjust monetary policy at an appropriate pace.
Overall, while the major central banks are quickly trying to reshape their forward guidance for monetary policy to ensure that consumer inflation trends move back below target, the pace of tightening needs to be monitored closely to prevent any undue tightening that could derail the fragile economic recovery.
A rapid increase in real interest rates could potentially lead to a disruptive revaluation of global equity markets, resulting in sustained and significant weakness in bond and equity markets. At the same time, delaying the tightening process could lead to inflation taking hold more fully, undermining economic activity and eventually leading to aggressive monetary policy tightening in the future.
As financial vulnerabilities remain elevated in several sectors, monetary authorities should provide clear guidance about the future stance of policy to avoid unnecessary volatility. Until then, these risks highlight the need for asset diversification in the construction of investment portfolios.