Central Banks Surprise Investors and Themselves

There are a lot of problems to worry about over the long term. For a considerable time, economic growth and investment returns are likely to be less than the long-term averages. Developed economies are burdened with excess debt in both the private and public sectors.

Populations are aging in the developed world. Central banks are running out of traditional methods to help their economies. Income and wealth inequality have increased, largely due to the effects of quantitative easing.

Focusing on the potential consequences of those long-term problems paralyzes a lot of investors. It’s better to concentrate on the next one to three years. Let’s focus on the recent cyclical trends. As always, we look at the things that matter to markets. That will help us earn solid returns today, and we’ll be better able to respond if and when the consequences arise.

Central banks continue to be the primary influence on the markets. Yet, some of the consequences are surprising even the central bankers.

Global monetary stimulation was instituted in February after the panic over a potential devaluation of China’s currency and other problems caused steep market slides. The monetary stimulus halted the deflationary trends that were in place.

Interest rates declined. Stock and commodity prices increased.

The effects, however, weren’t equal across the globe and markets and weren’t as intended.

U.S. stock prices rose the most, and treasury rates sharply declined. U.S. interest rates continued to decline even after Fed officials again insisted another interest rate increase was likely. The dollar declined, though it was supposed to appreciate. Meanwhile, European and Japanese stocks were flat or down, though their central banks were the most aggressive and did so with the expectation of increasing stock prices.

It appears that investors in Europe and Japan were concerned the monetary easing would reduce the value of their currencies and not help their economies much. So, they purchased U.S. assets and put currency hedges in place.

That pushed up the prices of U.S. stocks, bonds and the dollar. Until recently, interest rates on long-term bonds continued to decline even after the Fed indicated it was likely to raise rates soon. The investment moves also helped emerging market stocks and

bonds more than European and Japanese counterparts. Most of the money that was supposed to stimulate Europe and Japan moved to the United States.

This trend largely has run its course. U.S. interest rates are too low relative to the cost of the currency hedge.

Also, the Fed now is more likely to raise rates a couple of times, and the European Central Bank held policy steady at its September meeting. Investors are starting to realize this, as I discuss in this month’s Portfo- lio Watch.

Global monetary stimulus is likely to continue, despite

possible modest interest rate increases from the Fed, but it is less effective than  in the past. The U.S. economy is receiving stimulus from rising home prices and wages and from low unemployment. Even so, the stimulus is volatile. Home price increases and stock market gains both faltered recently.

The result is that economic growth in  the U.S. slowed a notch or two in the last  few months. Yet, growth still is positive and probably around the long-term average. The recession in manufacturing

seems to be finding a bottom. U.S. growth going forward is likely to depend on a combination of international growth and rising U.S. household incomes.

U.S. stocks have outperformed the rest of the world, with total returns exceeding economic growth and earnings growth  by wide margins. In fact, earnings overall have declined and analysts regularly are reducing their earnings estimates. The flow of money from central banks was the primary boost to stock prices, causing valuations to rise.

Slower economic growth, falling earnings and high valuations sharply reduce the margin of safety in U.S. stocks. That’s why our recommended U.S. stock allocations are modest. I also recommend investing in mutual funds that concentrate on a few quality stocks instead of a broad- based fund or market index.

Inflation and commodity prices have been rising since their lows of early 2015. The rate of increase doesn’t require strong action from the Fed to control inflation.

But inflation is higher than investors are anticipating. Markets continue to be priced to indicate investors expect inflation and interest rates to stay at recent lows for a long time. I think investors are going to be surprised by inflation and interest rates higher than is priced into the markets.

In response to these trends, we sold long-term bonds and utility stocks early in the summer. We also bought investments that benefit from rising commodity prices and emerging markets growth.

Turning back to the long-term trends, there’s good news in this unpredictable, unique election year. Presidential nominees of both major parties advocate fiscal policy changes, including increased infrastructure spending. I’ve been saying for a while that monetary policy can’t carry the economy by itself much longer. Fiscal policy needs to change, and we might see that happen after the election.