I’m fortunate to live in a city that is nestled in the Blue Ridge Mountains. Last week we had a rare fire that destroyed about 3,000 acres of forest and hiking trails. Flames could be seen from various cities and smoke could be smelled from as far as 30 miles away.
Last week was a slow week in markets and I wanted to write a commentary that would take a step back from the week to week action to look at the big picture, where we have come from and where we stand now. As I was sitting down to write this week’s commentary, I couldn’t escape the seemingly odd link between forest fires and what we are currently witnessing with central banks.
One of the things that firefighters and National Park officials do to prevent widespread forest fires is to set controlled or prescribed burns. These prescribed burns are a technique used during cooler months to reduce fuel buildup and prevent hotter fires from occurring. The controlled burns are also necessary for the natural life cycle of the forests. The small burns help to stimulate the growth of the more desirable forest trees which require heat in order to open their cones and disperse seeds.
These smaller fires are critical to the long-run health of the forests and it inhabitants. In fact, many attribute the Cedar Fire in California back in 2003, to the fact that there had been cut backs in the number of these prescribed fires, which led to the most devastating group of wildfires in California’s history. The Cedar Fire, along with a dozen other fires, burned close to 1 million acres in a 2-month span from October to December 2003. This has been referred to as the “Fire Siege of 2003.” Central banks have all but eliminated prescribed burns from the financial markets for over 7 years and we are witnessing the beginning of a fire siege right now.
Since the Financial Crisis, central bankers have not allowed markets to move freely and experience their natural life cycles. At every minor dip in the road, central bankers have been there with more stimulus, more easing, and ever lower rates. The truth is, for a long while, these actions worked. They didn’t work to stimulate the global economy but they certainly pushed asset prices exactly where the central bankers wanted them to go. Stocks worldwide went higher and currencies went lower. If you don’t believe the fire siege is underway, then look no further than the Eurozone and Japan.
Both the BOJ and the ECB have come out with new rounds of stimulus this year to burn the currency and push equity markets higher. Investors have responded to the BOJ’s actions by pushing the Yen up 8% and the Nikkei is off 8% year-to-date. Likewise, the ECB came out guns blazing and quite literally through every available stimulus tool at the market. The response has been a 5% gain for the Euro and a 4.6% loss for Eurozone equities.
Investors are becoming more and more frustrated with the lack of results. The only thing that has improved over the last 7 years are the stock portfolios of investors, what really matters, the global economy, is worse off. It's worse off because economic growth hasn’t come close to gaining upside momentum and yet we have more debt than we have ever seen.
When you look around at the world we are living in today you have to both marvel and scratch your head. China’s latest GDP growth rate is the lowest since Q1 2009. The US’s long-run average GDP growth rate is around 3.2%; it's currently running at 2% and headed lower. Japan’s GDP meanders around the 0% line and hasn’t shown any signs of life since early 2010. The Eurozone is the tallest of the pygmies, as its GDP growth is sitting at 3-year highs, but still below its long-run average of 2%.
The central banker’s answer is apparently if 0% doesn’t work you just keep cutting. Negative interest rates are all the new fad. Poor savers worldwide have been getting hosed for years now and just can’t catch a break. 40-year bonds in Japan are paying 0.3%! 30-year bonds here in the US are paying just 2.7%, down from over 4% just a few short years ago.
But CNBC and the Fed would say don’t worry, the S&P 500 just broke to new all-time highs, so everything must be ok. What you probably haven’t heard is that this current post-Financial Crisis bull market in US equities is the second longest of all-time. The current bull market is 2607 days old, exceeding the bull market of June 1949 to August 1956 by one day. What’s more interesting is that all asset classes have struggled to rally since the end of the QE3 here in the US. I read last week that a portfolio allocated to 50% equities, 35% bonds, 10% commodities and 5% cash would have doubled from $100 at the March 2009 lows to $198 by the end of QE3 in October 2014. Since then, that same portfolio would have fallen 3%.
The US and its equity market are the outliers. The rest of the world’s central banks, outside of the Eurozone, China and Japan, have also been using easing policies as a source of stimulus. The difference is, there has been no “wealth effect” for quite some time. Latin American equities peaked back in 2011 and are now trading at 2009 levels. Most of the Asian emerging equity markets peaked back in 2012 and are now sitting at 4-year lows.
All the while, central bankers continue to press the gas pedal on easy monetary policy. Yet for 7 years, they haven’t been able to stimulate sustainable, acceptable levels of growth and outside of the US, bankers can’t even seem to goose their own equity markets. What they have been and continue to do simply does not work. Period. The only thing they are accomplishing is making the entire financial system more and more unstable.
Just like forests, global financial markets are an ecosystem. Every ecosystem has its own life cycle that it has developed to not only survive but also to thrive. Central bankers have arrested the natural cycles of financial markets.
At some point, all ecosystems, financial markets included, must find homeostasis. The markets will work off their excesses, whether the central bankers want it or not. The price action in the Eurozone and Japanese markets since the newest round of central bank stimulus is the first sign of this homeostatic action.
There is plenty more excess to get worked out of the system. The longer an ecosystem is artificially managed, the more extreme in duration and magnitude, the cycle will be, once its allowed to occur. Make no mistake about it, the net result in financial markets of the collective actions of central bankers will be nothing short of a fire siege.