Ten years after the global financial crisis, the U.S. Federal Reserve is signaling that it will shortly begin to trim its balance sheet. No one knows how far or how fast—that will depend on circumstances—but it is likely to start very slowly. The imminent winding back of quantitative easing (QE) has caused some concern about the likely trajectory of global asset prices. Figure 1 is indicative of these concerns.
It’s not quite the same relationship as between the Fed’s balance sheet and the S&P 500, but there is the same coincident upward trajectory.
So, should we worry? Not unduly, for three reasons.First, global growth is now self-sustaining. QE was an emergency policy measure signaling that central banks would “do whatever it takes” to maintain global growth and a target level of inflation. In an economic recovery that was weak, due to lack of confidence and credit growth, it is no surprise that financial markets became dependent upon it. The fact that the S&P 500 has now unhitched itself from the central bank’s balance sheet indicates that the recovery is self-sustaining.
Second, at a global level, central bank balance sheets are still expanding, with the ECB and Bank of Japan still pursuing QE. While 2018 will probably see peak QE in the West, with the balance sheets of the G7 economies plateauing for a while and then gently declining from 2019, there is still a degree of stimulus to come. Even after this point, it’s likely that the central bank of China will have to intervene, as the economy there goes through some sort of managed financial crisis.
Third, we still have a global savings glut caused by the relocation of production from the low-saving Western world to high-saving economies of Asia (China in particular) over the last 20 years. This savings surplus will continue to depress world interest rates for at least another decade. There is a good argument that demographic change, namely aging, will reduce the supply of global savings and push interest rates up. Retirees, whose global numbers will steadily increase from this point, tend to run their savings down. But this will take place slowly, over the next 20 years or so.1
Still, investors would be well-served to prepare.
There is probably a medium-term cyclical threat to asset values, including real estate, roughly one to three years out. Short-term interest rates will rise to a point that slows economic growth and raises market discount rates. Investors would do well to prepare for that now, but it won’t be permanent and, in due course, interest rates will fall back to very low levels. But there is no need to fear the imminent winding back of QE in the U.S., as some commentators have suggested.
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1Charles Goodhart and Manoj Pradhan, Demographics will reverse three multi decade global trends, Bank for International Settlements.