The good news is that world equity markets have popped back from their mid-February slump, after the world’s major central banks eased liquidity. The Federal Reserve backed off from its threat to raise interest rates four times during 2016, and the market now expects the overnight interest rate to stand at just 0.50% a year from now, vs. an expectation of 1% at the end of 2015. The Bank of Japan has pushed interest rates into negative numbers, and the European Central Bank has maintained its negative-interest rate stance and pledged to buy corporate bonds as part of its quantitative easing program.
With $7 trillion in government bonds offering negative yields, investors have returned to stocks. That’s the good news. The bad news is that the global liquidity effect on world equities is fading. Negative interest rates recall the old vaudeville joke about the comedian who offered to shoot himself onstage: What do you do for an encore?
The trade-weighted dollar index DXY is a pretty good proxy for global deflation. The Fed’s mistaken belief that the US economy was on a normal path to recovery and that US interest rates should rise back to normal levels triggered a massive rise in the dollar index and a corresponding collapse in commodity prices, led by oil. As the dollar index rose, world equity markets fell. The inverse relationship between the dollar index and the most comprehensive measure of world equity prices, the MSCI Global index, is clear from the chart above.
If we look at the same data in a scatter plot, the relationship clearly shakes out into two distinct zones.
Markets bounced back when the dollar index fell from 100 to 94 between January and April, but they bounced to a level about 15% below where they stood the last time the dollar index stood at 94. Markets are still liquidity-driven, but they are less responsive to the monetary stimulant.
That’s not surprising. World trade volume grew just 1% during 2015 according to Holland’s CPB Institute, which means the global economy barely has one nostril out of the water. In dollar terms, world trade shrunk by 12%, which means that corporate borrowers around the world have less income with which to service dollar-denominated debt.
The US economy will grow by just 0.3% during the first quarter according to the Atlanta Federal Reserve’s GDP NOW tracking model, or by 1.1% according to a similar model offered by the Federal Reserve Bank of New York. In either case, the US economy is dead in the water, as is Japan’s (forecast at 0.5%) and Germany’s (forecast to grow 1.6% this year). All the recent US data — retail sales, industrial production, capital goods orders and housing starts — have come in well below the market consensus, which is to say that the already-pessimistic consensus isn’t quite pessimistic enough.
Economies cannot operate on negative interest rates for very long: pension funds, insurance companies and other savings aggregators cease to function in a negative-yield environment, as Blackrock CEO Larry Fink complained April 14. Negative yields undermine the savings mechanism; in effect, they burn the future in order to stimulate the present economy. Most of the central banks have shot off their last bullets. The Federal Reserve, of course, could cut the federal funds rate back to zero, admitting that its strategy of the past seven years was a colossal failure. What the numbers suggest, though, is that the great era of equity rallies driven by monetary ease is coming to an end.