Ever since the financial crisis in 2008 an experimental monetary policy has been in place, known as quantitative easing. The Federal Reserve expanded its balance sheet from about $800 billion to $4.5 trillion. It bought mortgage bonds and treasury bonds. This had a big effect on almost every asset. Lowering treasury yields made pension funds, who traditionally bought bonds, buy stocks to make up for the lost returns. This also artificially increased the price of bonds, as interest rates came down. Additionally, everyday savers can no longer earn decent returns on deposits, so many have gone searching for yield, which means buying stocks, one of the most riskiest investments in theory. Accompanying that risk is increased volatility in value. Stocks (and bonds) have become the only game in town. This has changed the way markets behave. Valuations have reached historical levels. For example, the price to sales ratio of the S&P 500 is the highest in history. Or the price to earnings ratio, which is third highest in history, only behind the 1929 bubble and the 2000 tech bubble.
The Federal Reserve expanded its proverbial toolbox from traditionally only setting the short-term rate banks borrow at, known as the Fed funds rate, to now being able to buy bonds. The Fed acted as a leader in this expansionary policy as other central banks such as the Bank of Japan (BOJ) and the European Central Bank followed in its footsteps. The experimentation with policy started with the Fed, but the other central banks have pushed the envelope both in the size of the asset purchases and what type of assets are purchased. The Bank of Japan is buying ETFs which has the side effect of lowering the efficiency of capital markets. In a free market, a firm’s stock performance reflects its business performance. When the BOJ decided to buy ETFs which house most stocks, individual stocks started to perform well regardless of the underlying businesses performance.
As I mentioned, the size of the purchases is varied. The chart below shows the central banks’ balance sheets as a percentage of their respective country’s GDP. The Swiss central bank has gone wild with stock buying, even delving into individual stocks. The bank has purchased large-cap American stocks like Apple, Amazon, and Google. To simplify, the Swiss central bank is printing currency and purchasing American stocks which means the free market isn’t exactly free.
Like with the Japanese ETF purchases, the global central bank balance sheet expansions have consequences for our markets. Anytime a central bank buys stock in a larger firm and ignores a smaller firm, it boosts the prospects of the larger firm at the behest of the smaller one. Another factor at play is the central bank policy of low interest rates. Low interest rates have especially helped large firms issue bonds. This helps them raise money for buybacks and acquisitions which increase their competitive advantage over small firms. In other words, this creates an additional catalyst for the stock market, at the expense of the company’s balance sheet in the long run with an increase in debt.
Here is a chart of nonfinancial company debt outstanding:
These factors all lead to the chart below. As you can see, there is a breakdown by market cap of forward profit margins. The S&P 500 represents the large caps. The S&P 400 represents the mid-caps. The S&P 600 represents the small caps. The small cap profit margins have sagged since 2013, while the large cap profit margins are at the cycle high. The small cap profit margins are up about 1.5 percentage points from 2009, while the large cap profit margins are up about 4 percentage points. The inequality gap between the rich and the poor is often discussed, but, as you can see, the inequality gap between large and small cap profit margins is also expanding.
I laid out some of the consequences of the expansion of central bank’s balance sheets. Two other factors worth keeping in mind are that the economy has recovered since the financial crisis in 2008 and that this recovery has been the weakest one since 1949. When deciding in hindsight whether this expansionary policy was a good idea, you must look at the benefits and costs of it. The benefit was stabilizing the financial system. If the Federal Reserve wasn’t involved, the recession would have been worse. The question is whether stabilizing the financial system in 2008 is a worthy tradeoff for the consequences to come?
This question is still unanswerable because we still do not have all the facts at hand. Even though the policy was started in late-2008, we still don’t know what the end-game is and how it will be executed. Is the strategy to get in and get out or is it to maintain the size of the balance sheet in calm economic times and expand it in times of peril?
The reason I am discussing this topic is because we are about to see, after about 8 years, what the end game is and how it will affect markets and the economy. How will the economy and stocks respond to central banks stopping their collective asset purchases and even shrinking their balance sheets?
The chart below gives you an estimated timeline of when this situation will play out. The rate of central bank purchases is about to start to decline. Their size will start to shrink in late-2018 for the first time since a brief period in late 2009. Step one will be the ECB slowing its asset purchases from 80 billion euros to 60 billion euros per month starting in April. The ECB purchased Italian bonds which helped stabilize its economy which has been rocked by a banking crisis. The reason for this slowdown in purchases despite the dire fate of the Italian banking system is the threat of inflation. Germany feels the effects of inflation without the gains Italy sees, so its politicians push for the ending of ECB purchases. The other effect at work is that the Federal Reserve is leading global central bankers down this policy of shrinkage.
The answer to the question of whether the unprecedented expansion of global central banks’ balance sheets was a good policy to proceed with to stabilize the economy in 2008 will be answered in the next 18 months. The answer may start to make itself known next month when the ECB slows its purchases. This monetary cliff is the single biggest factor which will alter how every market is priced. Every market, whether its pork bellies or German Bunds, is interconnected globally. It’s important to pay attention to how this situation plays out as we witness history in the making.