Get Ready for More Volatility in 2018

Inflation and rising interest rates will shake things up this year.

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roller-coasterCanada’s economic boom in 2017 surprised economists and supported strong labour numbers. Yet, inflation also remained dormant, “which created this Goldilocks environment and, therefore, very strong financial market returns for the year,” says Luc de la Durantaye, the head of asset allocation and currency management at CIBC Asset Management Inc.

That won’t be the case this year, at least when it comes to inflation. Instead, says de la Durantaye, “Our forecast is [for] inflation that starts below central banks’ targets but rises toward [them].” He’s also calling for 3.6 per cent global growth, which he characterizes as “fairly optimistic.”

He’s not alone in his view, with both big banks and investment firms also calling for continued growth and inflationary pressure. In a January 2018 outlook report, the World Bank Group said global growth “reached three per cent in 2017, its strongest rate since 2011, in a broad-based upturn.” The group predicts that will “edge up to 3.1 per cent in 2018” due to the recovery of emerging and developing countries.

So what are the potential inflection points for 2018? De la Durantaye says it’s key to consider whether the following events could “derail this rosy environment.”

One such event is another increase in the Bank of Canada’s interest rate, which was raised to 1.25 per cent today. “Particularly in Canada, the labour numbers have been surprisingly strong. Certainly from a [Bank of Canada] perspective, which is data-dependent, that turns the pressure on for them to review their policy sooner [rather] than later,” says de la Durantaye.

But in making its decisions, the central bank is weighing multiple headwinds. “It’s a difficult balancing act for Canada, given NAFTA uncertainty in terms of the negotiation. [There’s] also the high debt levels that we have in the household sector and the housing market,” he says.

The U.S. Federal Reserve, the Bank of Canada and the Bank of England all raised interest rates in 2017. This year, “you may have other central banks that are going to get on the bandwagon,” says de la Durantaye, adding that the European Central Bank is likely to end its quantitative easing. Plus, there’s speculation about the Bank of Japan changing its policy stance, and the central banks in Sweden and Norway are expected to make moves.

Inflation surprises

One reason inflation could rise is “tightening labour markets in Canada, the U.S. and even in Germany. There are certainly secular reason[s] why inflation has remained subdued,” says de la Durantaye, but the probability of “an inflation surprise in 2018” is higher than the market expects.

Any of these events could cause more volatility this year, he says.

Another issue to consider is real estate markets remaining overpriced, “not just in Canada but also in Sweden, Australia and Norway,” says de la Durantaye. As interest rates rise, that ongoing issue “could raise financial stability concerns in 2018.”

Investment tips for 2018

In 2017, equities outperformed fixed income. “That has most likely created a drift in [portfolios] away from basic policy — [they’re] probably now overexposed to equity relative to fixed income,” says de la Durantaye. As such, it’s “time to think about rebalancing.”

Ahead of potential interest rate and inflation increases, de la Durantaye is looking at portfolio duration. “In a rising rate environment, you may want to consider having a lower portfolio duration,” he says.

As well, says de la Durantaye, “Equity portfolio would probably want to be geared toward more cyclical markets, given the strength of the economic outlook, and less geared toward rate-sensitive sectors.”

Finally, the U.S. equity market rose “to a historically high valuation [in 2017], relative to emerging markets and some European markets.” De la Durantaye recommends trimming U.S. exposure and making room for emerging markets.

This article originally appeared on our companion site, 

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