"This is the end
This is the end
My only friend, the end
It hurts to set you free
But you'll never follow me
The end of laughter and soft lies
The end of nights we tried to die
This is the end"
--The End, The Doors, 1967
This is the end of an era. Since the calming of the financial crisis, capital markets have seen continuously accommodative monetary policy from at least one of the four major global central banks. But after eight years of a policy approach that has done little more than support anemic growth and stoke a status quo shattering populist revolution, the futile exercise of pumping endless streams of monetary liquidity into the global financial system is finally coming to an end. And it stands to wonder how asset prices that have been inflated beyond all recognition in the process respond once this extraordinary monetary support is finally stripped away.
Global central bank balance sheets have been expanding feverishly since the outbreak of the financial crisis back in 2008. Over the past nine years, the total assets of the four major global central banks - the U.S. Federal Reserve, the European Central Bank, the Bank of Japan, and the People's Bank of China - have increased in size by more than $11 trillion in effectively tripling from just over $6 trillion in 2008 to nearly $18 trillion today.
To say that this balance sheet expansion has been a primary driver of rising asset prices in general and U.S. stock prices (NYSEARCA:SPY) in particular is an understatement to say the least.
This is what makes recent developments with global monetary stimulus so notable and surprisingly overlooked by the market at the present time, most likely because a year end rally is fully underway in stocks. For the first time in several years, the collective balance sheets of the four major global central banks actually ticked measurably lower. While this may on the surface look like something completely irrelevant, it is in fact most noteworthy, as it represents what is effectively the very tippy top of what is effectively a wild roller coaster ride. Everything may seem calm and steady at the moment, but what may follow going forward could end up being eye watering.
Where'd My Stimulus Go?
So why exactly is the market set to react negatively to the loss of monetary stimulus now? After all, didn't the U.S. Federal Reserve end their asset purchases back in October 2014? And although stock price performance has been largely flat with a few downdrafts along the way, things have held up reasonably well since. What's to worry about then?
It is true that the U.S. Federal Reserve has been out of the stimulus game for nearly two years now. But as mentioned above, the Fed is not the only major global liquidity provider. For while the Fed ended its QE3 stimulus program in late 2014, the People's Bank of China (NYSEARCA:GXC) kept on going with a few hundred billion dollars of asset purchases into mid-2015.
It is worth noting that the PBOC eventually contracted its balance sheet fairly sharply by around $700 billion in the second half of 2015 into early 2016 before leveling it out. And it should be considered no coincidence the performance of the U.S. stock market over this same time period.
But perhaps more importantly, it was right around the time that the Fed was folding up their monetary tents in late 2014 that the European Central Bank (BATS:EZU) and the Bank of Japan (NYSEARCA:EWJ) were about to unleash their own monetary stimulus tsunamis onto the global financial system.
For the European Central Bank, after an extended period of overall balance sheet decline as euro area credit institutions repaid their LTRO loans, the ECB embarked on a major asset purchase program of their own that has added $1.6 trillion to their balance sheet over the past two years.
As for the Bank of Japan, their monetary stimulus program has been even more extraordinary. While they have been expanding their balance sheet all along, they essentially started to go hog wild just as the Fed was getting out of the asset purchase game. Over the past two years, the BOJ has nearly doubled their balance sheet to $4.5 trillon, which is nearly a stunning 100% of GDP for the country.
What is notable here once again is the following. Much like the Fed and the PBOC before them, the Bank of Japan's balance sheet actually contracted in a measurable way for the first time in a couple of years. And given that BOJ head Kuroda has not only shown reluctance to add any further stimulus but also recently upgraded his economic outlook (this is not the first time that Japanese policy makers have upgraded their economic outlook during the more than a quarter of a century that it has been stuck in a deflationary spiral), it is more than likely that the BOJ may increasingly shy away from expanding its balance sheet any further going forward and may even look to gradually contract it from its currently lofty perch.
The net result of the combined actions of these four major global central banks has been the following. While the Fed has been on the sidelines and the PBOC is also now effectively on the sidelines after sharply contracting its balance sheet in late 2015, the astonishing stimulus efforts from the European Central Bank and the Bank of Japan has resulted in what turned out to be the largest ever calendar year central bank balance sheet expansion in 2016 with over $2.5 trillion being pumped into the global financial system. So not only was this not a year without extraordinary monetary stimulus in 2016, it was a year where it was flowing at a stunning record pace.
So what did global markets have to show for all of this monetary stimulus at the end of the day? The U.S. economy remained sluggish. Economies outside of the U.S. continued to falter. Up until the Trumplosion following the election, U.S. stocks were flat for the year. Outside of the U.S., they are still effectively flat for the year. In short, even more of the monetary stimulus that used to send stocks on a magic carpet ride higher is now just enough to keep it steady with a few short-term bursts to the upside offset by equally jarring bursts to the downside. Whether this latest upside burst since the election proves sustainable remains to be seen, but if history is any guide, we may see some more downside shocks going forward versus what we have seen in the recent past.
The Other Side Of The Roller Coaster
What is a real shame about all that has happened from a monetary policy perspective during the post crisis period is the following. So much monetary treasure has been created out of thin air and deployed in a policy experiment that is completely untested. It would have been one thing if this policy approach worked. But despite their most extraordinary efforts, it simply came nowhere close to working in generating sustained economic growth for the global economy. In the process, it has left behind global asset markets including stocks that are grossly overinflated and will not have a growing economy to help fill in below these now extreme prices.
Where do the four major global central banks stand today? The asset purchase stimulus game that has gone on continuously since the calming of the financial crisis is quickly coming to an end. The Fed is already out and is now tightening. China (NYSEARCA:FXI) is also out and has been for some time. And while one never knows if they may restart the monetary stimulus engines at some point down the road, their current economic challenges suggests that this is not likely the policy approach they are likely to adopt any time soon. And the Bank of Japan is also now heading to the exit with more stimulus. The only bank that remains in the game is the European Central Bank, but even they recently tapered back their own purchase program from 80 billion to 60 billion euros per month on a program that is now set to conclude at the end of 2017. In short, the net $2.5 trillion that was pumped into the global financial system this year is set to be replaced by $700 billion or less in 2017 with the prospects of any further asset purchases in the future going to zero and potential further balance sheet contraction to follow.
All of this leads to the following simple line of reasoning. If asset prices have been grossly inflated beyond all recognition thanks almost exclusively to extraordinary monetary policy efforts by global central banks, it is only logical to conclude that they will no longer continue rising when this stimulus goes away. Better yet, they may subsequently painfully deflate once all of the air pumped into asset prices goes rushing back out once these same central banks start contracting their balance sheets. Only time will tell, but the one thing that we do know is that the "candy" part of this exercise is quickly coming to an end.
But what about the pro-growth policies supposedly on their way in the U.S.? Perhaps this will provide some support. But the only problem is that higher interest rates from the Fed and the bond market (NYSEARCA:TLT) are definitely here today while increasing economic growth may come in fits and starts at some unknown time in the future. As a result, by the time these pro-growth policies kick in if they ever do at all, it will likely be way too late to receive the market baton from monetary policy makers that are in the process of stepping away now. In short, stronger growth is likely to come too late to matter if it ends up coming at all.
While the stock market is all whipped up right now over the prospects of future fiscal policies that may actually feed through to growth in the U.S. economy a couple of years down the road at the earliest, it continues to blow off the more immediate negative forces confronting it today including higher interest rates and the prospects not only for no further global central bank balance sheet expansion, but actual balance sheet contraction going forward. If recently unfolding central bank policy trends continue, it promises to be an interesting ride for the markets over the next few years. And along with increased volatility, the potential for a policy accident cannot be completely ruled out.
The end can sometimes be painful, but it is important to remember that enduring pain is often required to arrive at a more promising new beginning. And while the stock market may struggle during any such future period of balance sheet contraction, it is important to remember that other areas of the market will be set to perform well depending on how the economic environment unfolds along the way.
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Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I am/we are long TLT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long selected individual stocks. I also hold a meaningful allocation to cash at the present time.