Much fanfare has been made of the synchronized global expansion that began in the third quarter of last year. Repeatedly, since the crisis, both official (central banks) and private economic forecasters have been embarrassed by economic growth and inflation missing projections. Therefore, this past year has been unexpected surprise, as growth beat expectations in most countries around the world. Average forecasts for 2017 Global GDP (according to Bloomberg) at the beginning of last year began at 3.2% on a year over year basis. Instead, full year global growth came in at 3.6%, and average forecasts for next year expect an acceleration to 3.7%. A few bold economists from major banks (Goldman Sachs and Barclays) are predicting 4% growth or better. Assuming this year’s forecasts turn out to be accurate, we will have experienced the best two-year growth span the world has seen since the immediate recovery following the crisis.
Before we break out the champagne, there is nothing particularly extraordinary about these levels of global GDP growth (3.6-3.7% YoY). This is pretty much in line with average levels going back to 1980. However, if we reach the 4% rate as some anticipate, it would certainly be cause for some celebration. For the U.S., in particular, along with expectations throughout last year for a record corporate tax cut (see Candy and Liquor for X-mas ), it has been a potent elixir fueling business confidence and stock market gains.
While there is considerable variation in the individual country drivers of growth, as I see it, the common theme is undeniable. Interestingly, there has been no lack of coverage of the amount of global monetary stimulus over the last few years, but there seems to be a complacency about the prospect that stimulus will be curtailed. Repeatedly in this cycle, any withdrawal of stimulus has led to a relapse in growth. Nevertheless, this notion is not on most investors’ minds right now. At least, not yet.
Our Daily Bread
Man ate of the bread of the angels;
he sent them food in abundance.
Psalm 78: 25
Global central banker angels have been quite kind to investors in recent years. The slightest hunger for increased liquidity has been granted expeditiously. In this environment, investment professionals have spent an inordinate amount of time examining the largesse, often focusing on meaningless minutia. Monetary policy is known to have long and variable lags between initiation and effectiveness, which augments the difficulty of analysis. In the post-crisis world, monetary complexity has risen by several orders of magnitude, as central banks have attacked secular stagnation with a number of extraordinary measures.
It’s easy to get lost in the weeds when considering the various machinations of individual central banks. Putting aside the mind-numbing alphabet soup of the various credit facilities, and focusing on the big picture of balance sheet expansion, a rather simple story becomes apparent. Virtually every attempt to “normalize” monetary policy, which typically only involved a respite in central bank purchases of securities, has led to a weakening in economic conditions.
Now one might say, “Wait a minute. The Fed stopped QE at the end of 2014, and has been raising rates since the end of 2015.” True, but rate hikes have been at a glacial pace, and until recently, the Fed has been reinvesting maturing securities, keeping its balance sheet stable. In addition, both the European Central Bank (ECB), and the Bank of Japan (BOJ) have been conducting extreme QE since early 2015. Europe has augmented that with negative interest rates. China, after drawing down its balance sheet around -10% in the latter half of 2015, has since expanded past the early 2015 high point. In aggregate, what we have is an oscillating trend upward in the major global central bank balance sheets. Chart 1 shows the “Big 4” (U.S., Eurozone, Japan and China) central bank balance sheets aggregated (in U.S. dollars), along with the MSCI ACWI Equity Index (includes Developed and Emerging markets).
“Big 4” Central Bank Balance Sheets (Millions of US$) with MSCI ACWI Index
Data Source: Bloomberg
The strong correlation between balance sheet expansion and equity markets is unmistakable, yet, it’s not a revelation. Many were pointing out the strong relationship between the Fed’s balance sheet and the S & P 500 during the implementation of “QE2” and “QE Infinity” between late 2010 through 2014. Back then, with the Fed being the most important central bank globally, and actively conducting QE, there was more focus on the connection. However, with the onus of liquidity provision being met by a combination of Europe, Japan and China, many seem to be missing the continued importance. Complicating the analysis is the fact that, unlike the Fed, other central banks have gone through several periods of balance sheet contraction. Therefore, given the fungibility of global liquidity, aggregating the balance sheets of the largest central banks enhances clarity.
Returning to Chart 1, one can see the aggregate amount of balance sheet expansion stalled in the latter half of 2014 through 2015, which coincided with a global slowdown. To further illustrate, Chart 2 gives a disaggregated view of the “Big 4” central banks. The green line shows that China’s balance sheet contracted to the tune of about half a trillion dollars in the latter half of 2015, amid a sharp drop in global risk assets, and a significant slowing in the global economy. The Fed at the time was maintaining its existing balance sheet by rolling over maturing securities. Japan and Europe were adding stimulus, but the China withdrawal was enough to offset their efforts.
I do not believe it is a coincidence that global growth reached a low ebb at the point when China stabilized its balance sheet, and accelerated when the central bank began buying securities again. Once China flipped to expansion, global central balance sheets started rising again at a rapid clip. Within 6 months, the global economy had stabilized, and equity markets had recovered.
Big 4 Central Banks’ Disaggregated Balance Sheets (Trillions of US$)
Data Source: Bloomberg
By last year’s U.S. presidential election, the global economy had started to accelerate. This condition almost perfectly coincided with Republicans taking full control in Washington (the presidency with majorities in both the Senate and House of Representatives). The knock-on effect of the election was to focus investors’ minds on the beneficial effects to be had from deregulation and corporate tax cuts. In effect, magnifying the liquidity-driven global acceleration.
While the expectation of tax cuts and deregulation in the U.S. have added to the optimistic tone in U.S. markets, I don’t believe the current period of synchronized growth would exist had there not been a substantial increase in global liquidity. The primary point I wish to make is that despite a universal desire to declare victory against “secular stagnation”, the “new normal”, or whatever one wishes to call the economic backdrop of the last decade, the primary dynamic has not changed. Prodigious central bank liquidity is still a necessary condition for sustained growth in the global economy. Or, at the very least, there has been no proof to the contrary. Which of course, once again, begs the question: When will central banks (in aggregate) begin to slow the monetary faucets? And when they do, will the global economy finally be able to stand on its own?
With the Fed starting to draw down its balance sheet, Japan starting to taper QE, and Europe likely to do the same this year, the liquidity tide looks likely to recede. In addition, China has stated publicly that it is likely to move in the same direction ( China asks itself a tough question: Can it accept slower growth? ). Positioning and sentiment indicators for markets are sitting at multi-year highs. Stories abound of market complacency ( Overconfident? Wall Street worried by the lack of worry ). Bearish calls on the market have been made to look foolish for the past year, as pullbacks have been almost nonexistent. Calling recessions and market tops is always a precarious business. In the age of quantitative easing, it feels downright suicidal.
However, one thing we do know from the last decade: lack of liquidity infusions were enough to stall growth, and tank markets. So should we expect to keep chugging along at a brisk pace in the face of outright liquidity withdrawals? I do not wish to oversimplify the complexity of the global economy by proposing that the only metric that matters is central bank balance sheets. At the same time, I think investors should pay close attention to the shifting flow of liquidity. In the last decade, no indicator has been as prescient. For now, the flow is still positive on a global basis, but that looks set to change quite soon. Investors would be wise to pay close attention.