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A Barclays research report outlining the likely market effects of reduced monetary intervention by the U.S. Federal Reserve carries some ominous news for Canadian investors. According to Barclays, the two global asset classes that would be most negatively affected by a tapering of Federal Reserve's quantitiative easing strategy are European high yield debt and emerging markets equities – whcih also have significant effects on the S&P/TSX Composite Index.

The minutes of the most recent meeting of the Federal Reserve Board of Governors highlight increasing concerns amongst members that the central bank's $85-billion (U.S.) per month asset purchase plan is creating imbalances in the financial system and should be reduced. Markets immediately responded negatively when the minutes were released.

To prepare investors for market conditions with less central bank intervention, Barclays strategist Michael Gavin released a report this morning indicating that European high yield bonds and emerging markets equities would be most negatively affected.

For Canadian investors, this is a problem. European high yield debt has been closely associated with Canadian bank stocks (see first chart) which suggests that both would decline as the Fed withdraws. (The usual correlation/causation caveats apply, but the R-squared is very high at 0.78).

The Canadian equity market as a whole maintains a ridiculously high correlation with the MSCI Emerging Markets index (R-squared 0.86) (see second chart). So, if Mr. Gavin is correct that emerging markets equities will get hit when the Fed stops its buying program, the S&P/TSX Composite is also likely to face significant headwinds.

There is no consensus on when the Fed will end quantitative easing. For now, the end of QE does not seem imminent, particularly after Fed chairman Ben Bernanke stressed the dangers of withdrawing stimulus too soon during his recent testimony to Congress. But, more hints that the Fed will pull back are likely to have widespread negative effects on Canadian equities.

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Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 28/03/24 3:14pm EDT.

SymbolName% changeLast
XEM-T
Ishares MSCI Emerging Markets ETF
+0.42%30.77

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