Since 2008, the world’s five most reputable central banks have printed the equivalent of $11 trillion dollars in order to stabilize their economies and increase growth. Many thought these actions were needed to fend off the Financial Crisis, Great Recession, double-dip recession and/ or deflationary-spiral.
The largest central banks also have kept interest rates at historic lows. Currently, the European Union and Japan’s central banks (ECB & JCB) still maintain negative short-term interest rates to encourage investment and economic activity by penalizing idle funds.
With indications of a synchronized global economic recovery, money printing should subside and interest rates should rise. In fact, the US Federal Reserve recently raised its overnight interest rate by ¼% to 1% and announced intentions to start shrinking its balance sheet this October. Its balance sheet contraction could ramp up to $600 billion annually by 2019.
While the ECB and JCB continue to expand their balance sheets (the equivalent of printing money), they have slowed their pace. As their economies continue to improve, these central banks should eventually stop printing money and return to positive interest rates.
ECONOMIC OUTLOOK: SYNCHRONIZED GLOBAL ECONOMIC RECOVERY
Major central banks used the printed money to purchase bonds in an effort to lower longer-term interest rates. The JCB printed so much money that it now owns 43% of all Japanese government bonds. Both the JCB and ECB also purchased corporate bonds, which pushed down global interest rates. At the end of June, Japan’s ten-year government bond continued to trade with an interest rate below 0.1%.
Low rates have encouraged many government bond investors to purchase riskier bonds in order to receive higher interest rates. Bond risks include: credit risk, currency risk, duration (maturity) risk, geopolitical risk, inflation risk and liquidity risk. Despite these risks, Argentina was able to issue a 100-year bond in June, notwithstanding its history of defaulting on bonds six times in the last century.
Worldwide, countries and companies have benefitted from borrowing at low rates. Some have lowered their overall interest expense while increasing their total debt by locking in low long-term interest rates. As they use or distribute their bond proceeds, more money moves through the world economy and economic activity increases.
The excessive global printing of money and historic low interest rates meant to stimulate growth are finally having their intended consequences. Global consumer confidence is rising and unemployment is falling.
Even if European and Japanese government overnight interest rates move above 0% in the next twelve months, interest rates remain close to historic lows than historic norms. The continued below average interest rates will likely continue to drive investors into riskier bonds than they would normally buy. As governments and companies continue to take advantage of this, global economic growth benefits.
While the Federal Reserve may start to shrink its balance sheet before year end, global central bank balance sheets in aggregate might not contract until 2019 or later.
FINANCIAL MARKET OUTLOOK: CYCLICAL VS. STABLE INVESTMENTS
With global economic growth, the investor lexicon will shift from disinflation to inflation. Some investments should benefit from such a change while others will not.
Fear of recessions and deflation drove some investors into “stable” investments. These are investments that are considered safer in a weak economy. However, as global economies strengthen, many perceived “stable” investments may underperform or even lose money.
Investments deemed stable during the Great Recession included government bonds, preferred stocks, utility stocks, and even some consumer staple stocks. As demand for these investments increased, their prices rose and many are now too expensive.
While historically low interest rates benefit overall economic growth and many equity investments, modest interest rate increases can hurt bond returns. For example, in the last week of June, the ten-year German government bond interest rate rose from 0.25% to 0.46%, resulting in a 2% bond price decline. Thus, the holder of this 0.25% bond on June 23rd lost over eight years of bond interest income in just one week.
On the other hand, many cyclical investments are poised to benefit from economic growth and below normal interest rates. These can include dividend growth stocks, consumer cyclicals, financials and technology companies.
Not every investment category will move in lockstep with previous economic cycles. For example, new energy extraction technologies have resulted in plentiful supplies. This hurts many companies and countries that traditionally benefit from rising energy prices.
FUTURE CHANGES: WHERE TO INVEST
Studies show the average investor performing worse than most investment categories over time. This is partially due to buying investments that have already performed well in the proceeding five to ten years. While bonds performed well as interest rates fell to record lows, they should underperform as interest rates start rising.
Similarly, some investors are attracted to index funds dominated by the largest market-capitalization companies. Inflows into index funds are immediately invested and can push up prices of stocks held by these funds. With over $1 trillion moving into index funds this decade, some of their largest holdings appear overvalued.
Index funds are called “passive” investments because they replicate an index. On the other hand, “active” management is a security selection process typically with the intention of beating an index. These two management styles tend to move in and out of favor over multiple years. After eight years of strong index returns, some think a return to active management is overdue.
As other parts of the world realize economic growth, their economies may grow at a faster rate. Some US companies with international exposure should benefit from increased global growth. Many domestic firms derive almost half their sales from overseas. Their exports could surge and foreign subsidiaries could become much more profitable.
From 2003 to 2008 international stocks performed so well that by 2008 many headlines encouraged investors to overweight international securities. Since then, the international stock category has underperformed domestic stocks by a staggering amount. Today, some international stock categories have lower valuations and higher expected earnings growth rates than US stocks. Investors should selectively consider global and international equity mutual funds and exchange traded funds (ETFs) as part of their portfolios to enhance growth, dividend income, and diversification.