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Increased uncertainty when monetary policy becomes tighter

Many central banks around the world have announced plans for a tighter monetary policy to reduce inflationary pressures. This can involve both higher policy rates and smaller balance sheets. The development is much needed but creates great uncertainty in the financial markets.

Giving an exact answer to how large the effects on the capital markets will be is an impossible task. In addition to the central banks' measures, the growth rate, inflation and corporate profits affect development. In addition, there are geopolitical challenges such as the threat of invasion of Ukraine.

“Despite all the uncertain variables, we can conclude that more restrictive monetary policy will have a negative impact on the capital market. There will thus be greater demands for the delivery of economic growth and corporate earnings,” write SEB's investment experts in the latest edition of Investment Outlook.

They also conclude that a stricter monetary policy puts pressure on the valuations of financial and real assets.

“These correlations are the main reason why we have reduced the risk in our portfolios over the past six months,” the experts write in the report.

The fact that the economy is in a recovery phase with growth above trend facilitates the central banks' work to tighten, and thereby normalise monetary policy.

But growth cannot be taken for granted. The pandemic and the spread of the virus continue to pose a risk, as does the currently high inflation. This is causing a dilemma for central banks.

“Phasing out stimulative policy too quickly risks triggering a decline in asset prices and may  
stall growth. Too much stimulus can add fuel and lead to persistently high inflation,” the experts write.

Overall, the bank's economists expect that both the growth rate and the inflation rate will fall this year from unusually high positive levels in 2021 when the world recovered from the pandemic. In 2023, normalisation will continue but continue to be above or in line with the long-term trend.

Larger fluctuations to be expected in the financial markets

The central banks have been constant buyers of bonds for a few years, and they have also often announced in advance how much they intend to invest each month, which by definition effectively reduces volatility in the capital market. The effect has propagated between the asset classes.

“Although 2021 was a fantastic year with 50 per cent corporate earnings growth and impressive flows into the stock market, volatility was higher than in any single year during the period 2012-2019. This is an indication that the years of extremely stable markets are behind us,” write the investment experts in the report.

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