$9 trillion reasons the market is smiling
Global monetary policy is still easing and the combined balance sheet of the four major central banks, at $9 trillion, gives the stockmarket an upward bias.
David Kotok, co-founder of the funds management firm Cumberland Advisors, provides a useful insight into why markets are so buoyant at present. In a recent note, he argues that the world’s four biggest central banks – the US Fed, the Bank of Japan, the European Central Bank and the Bank of England – have given investors $US9 trillion of reasons to push markets higher.
According to Kotok, the old adage "sell in May and go away” only works when the US central bank is in tightening mode – raising interest rates, or withdrawing or restricting credit.
At present, the members of the Federal Open Market Committee, which makes important decisions on monetary policy, are divided. Some are have expressed concerns about further quantitative easing, while others are in favour. But it’s clear that the powerful US central bank boss Ben Bernanke favours a holding pattern – not wanting to do more, but not wanting to withdraw any stimulus.
As Kotok argues, it’s difficult for investors to adopt the "sell in May and go away” approach when the Fed is on hold and the US is not in recession. "The Fed has created a very large amount of excess reserves in the banking system and is maintaining the short-term interest rate near zero. One cannot describe that as a tightening policy.”
Even more importantly, he notes that the US Fed isn’t the only central bank that should be considered. There’s also the Bank of Japan, the European Central Bank and the Bank of England. "All of them are maintaining a near-zero interest rate policy, so the short-term interest rate on cash equivalents, whether denominated in dollars, yen, euros or pounds, is the same throughout the world.”
As Kotok points out, these four currencies combined account for around 85 per cent of global capital markets, if you include markets where the currencies are linked (such as the Hong Kong dollar’s link to the US dollar, and the Swiss franc’s link to the euro). So the world’s capital markets are being driven by the near-zero interest rates being maintained by these four central banks.
What’s more, Kotok notes that the combined balance sheets of the four major central banks has now hit an all-time record of $US9 trillion, boosted by the European Central Bank’s long-term refinancing operation, which flooded European banks with €1 trillion of cheap money, and by the Bank of England. And he predicts that the combined balance sheets of the four banks will likely balloon to $US10 trillion, because the Bank of Japan will likely adopt more expansionary policies in order to weaken the yen and fight deflation, while the European Central Bank will come under extreme pressure to launch another LTRO as Spanish, Italian and Portuguese bond yields climb higher.
"Remember, central banks have only this tool," he says. "Worldwide, national fiscal policies are too austere and too extended to be of any value in the attempt to encourage risk taking and economic growth; it all falls on the central banks. They have taken their rates to zero. They have twisted the yield curves where they can. All they have left is an expansion of QE in one form or another.”
But Kotok argues that with all four major currencies paying a zero interest rate, currency hedging costs have fallen sharply. As a result, it’s becoming much easier for investors to hedge their "carry trades” – where they borrow in one low-interest rate currency and using the money to buy investments in another currency. "We are now seeing some stockmarket exchange-traded funds that are designed to allow investing in a foreign market with a currency hedge, so that the investor can play a country’s stock portfolio without the currency risk. More and more sophisticated instruments of this type are being used in global investment management and construction."
According to Kotok, the expansion of the balance sheets of the four major central banks is the critical factor driving financial markets at present. Even though the US central bank is on hold, global monetary policy is not. It is still easing. And with such stimulative global monetary policy, stock prices have an upward bias.
"The conclusion is this: sell in May and go away. Nope. Not this year. There are $9 trillion reasons not to do it.”
However, he adds the important warning that investors should change their minds immediately if the central banks stop expanding their balance sheets in this collective fashion.