Managing risk around central banks’ interest rate calls

Managing risk around central banks’ interest rate calls

Managing risk around central banks’ interest rate calls

Forget President Donald Trump’s bromance with Kim Jong Un or his baiting of Justin Trudeau, most portfolio managers’ eyes are this week trained on the world’s leading central banks.

The US Federal Reserve is expected to increase its interest rate today, while there is the prospect of a hawkish tilt from the European Central Bank on Thursday as it decides when and how to end its bond-buying stimulus program. To round things off, the Bank of Japan’s policy decision is due Friday.

Chhad Aul, vice president, portfolio manager, Sun Life Global Investment, said the market has come to terms with 2018 likely being a four-hike year in the US and begun to price that in. The ECB meeting, therefore, will garner more attention.

Aul said: “We’ll pay attention to what the ECB will say about the unwinding of their quantitative easing programme because that will have implications for the longer end bond yields around the globe, quite frankly.”

With this potential double-whammy, Aul said portfolio managers may have to examine their strategy around a base case of expecting bond yields to continue to move higher, albeit not in a straight line.

He said: “We will be somewhat underweight versus our long-term allocation to bonds given where we see yield going.

“We’re still favourable on equities in the base case where we are getting late in the cycle and inflation has barely begun to pick up, but there is still room for growth to move higher. Even the multiple can move higher from here because, as we know, most cycles end with a move higher in the multiple, not a contraction, before that selloff.”

Aul’s base case is modestly overweight equities and underweight bonds, managing the portfolio risks around that stance. These include hedging by, for example, using options, which buys "a little insurance" in your portfolio.

“There are other layers to that defensive posturing as well,” he said. “Late in the cycle, as we are today, it begins to make more and more sense to use active management in the portfolio in terms of stock picking as opposed to how passive was great in buying the index when we were in the easy part of the market gains.

“Now things have become more difficult and more volatile, that ability of an active stock picker to add more value and protect and preserve capital at the same time becomes more and more important. There are multiple layers we can add to the risk management."

 

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