Central banks in the developed world made a historic shift in their policies the last few months, and many people haven’t noticed or don’t realize the significance.
The Federal Reserve and other central banks now are actively and preemptively fighting deflation. In the past, central banks were most concerned about containing inflation and they’d tighten monetary policy whenever price increases established some momentum.
In normal times, the Fed would still be tightening money now. The economy has been growing for more than 10 years and we’ve had a very long bull market in stocks. The unemployment rate is below 4%, and wage growth is increasing.
But in October, the Fed cut rates when the economy was growing, and stock market indexes were hitting record highs. It was only the third time in the last 30 years the S&P 500 closed at an all-time high the same day the Fed cut rates.
Central bankers are acknowledging two things.
The first acknowledgement is the financial crisis caused dramatic changes that will be with us for some time. Among them are strong secular forces keeping a lid on inflation and pushing the global economy closer to deflation than inflation.
The second acknowledgement is that central banking policies aren’t very effective anymore. Quantitative easing and other strategies used after the financial crisis became less effective after each use. They’re now largely ineffective in Europe and Japan.
Studies have shown, for example, that negative interest rates in Europe have done very little to stimulate borrowing and business investment.
Central banks now are very wary of anything that would reduce growth, fearing they won’t be able to reverse a downturn.
We’re in an extended period when the Fed and other central bankers won’t raise interest rates or tighten monetary policy. The markets can raise intermediate and long-term rates, as they’ve done recently, with long-term rates in the United States. But tighter monetary policy from the Fed and other central banks is off the table for a long time.
Most analysts and economists seem to think the change to easier money means the economy and stock market are going to surge as they usually do after the Fed shifts to easier money. Things are different now. The odds of a recession are decreased and it is more likely that modest economic growth will continue. But the downward pressures on growth and inflation aren’t going away.
We still want diversified portfolios, but less diversified than in the recent past. We’re going to make some changes in the portfolios this month, as you’ll see in Portfolio Watch.
The U.S. economy continues to grow at a decent rate, thanks primarily to consumer spending. Households have good support from a strong job market, with wages and salaries rising at the highest level since the financial crisis. Rising home and stock prices also support consumer spending.
As has been the case for a while, low investment by businesses is a worry. For growth to continue and for corporate earnings to be strong, businesses have to increase their investments at some point.
Otherwise, growth is likely to slow and the lack of business investment could lead to a self-reinforcing downturn.
Economic weakness in Europe and Japan also are concerns. As I said, even negative interest rates in Europe aren’t encouraging people to borrow, to invest or to spend. Europe’s slowing economy could lead to a sustained decline that spreads to other regions.
Of course, we need to continue to be wary of the consequences of trade conflicts, political populism, civil unrest around the globe and geopolitical problems.
While the central banks are getting out of the way, there still are reasons to be cautious and insist on a margin of safety in your investments.