At the end of 2017, investors witnessed one of the steepest climbs in stock market history. But the expectation that economic growth would continue into 2018 didn’t fuel these new all-time highs. Instead, it was the massive injection of fiscal stimulus pumped into markets worldwide — especially into the Chinese financial system — at the start of 2016.
The aim was to recreate the Plaza Accord: a global, coordinated effort to devalue the U.S dollar, reigniting economic growth in response to a recent U.S manufacturing recession that took its toll on the global economy. The decision to enact loose monetary policy created an abundance of liquidity in the global financial system, and when paired with the corporate tax cuts from President Trump, cheap money ebbed and flowed throughout the world.
As 2018 began, stock markets looked unstoppable; their charts resembled a parabolic curve. But for investors who thought they made a fortune were about to experience one of the worst weeks in stock market history: During the first week of February 2018, out of nowhere, all gains from the previous quarter were wiped out as the S&P500 Index fell 12.1% and the Dow Jones Industrial Average fell 11.7%.
This particular crash, however, was in a league of its own due to the absence of an obvious catalyst. There was no “Lehman Moment” or a natural disaster like Fukushima that would explain a sudden market sell-off. To find out what really caused the crash you had to overlook market fundamentals and dive deep below the surface of the global monetary system. There you will have found liquidity transitioning from net-positive to net-negative for the first time in over a decade.
The actual cause was the initial shock of several monetary policy changes made by central banks around the world. For a start, the ECB (European Central Bank) began to buy fewer bonds that provided essential liquidity to key European financial institutions, and this paired with regular interest rate hikes from the Federal Reserve, caused credit markets to gradually become illiquid. This not only had a negative impact on U.S markets but global markets too as a rise in dollar strength made it expensive for emerging markets to repay their dollar-denominated debts. With all these policy decisions creating a strain on the availability of credit, a shift from loose liquidity to tight liquidity spelled disaster for markets addicted to cheap money.
As we move into 2020, what’s interesting are the similarities between now and the spring of 2016, and the potential for history to repeat itself.
In response to U.S manufacturing indicators falling to recessionary levels, central banks around the world have reopened the credit taps by cutting interest rates and reintroducing QE (quantitative easing). From October 5th, 2019, the Federal Reserve has been injecting billions of dollars into the financial system on a daily basis — which has been infamously coined “Not QE” by many financial journalists and commentators. The European Central Bank (ECB) has also joined the QE party by reintroducing its bond-buying program; a farewell gift from long-standing ECB chairman Mario Draghi.
With loose monetary policy set to continue in 2020, if central banks and governments can achieve a Plaza Accord 2.0, markets will have a decent start to 2020. Though, the numerous market corrections we saw recently demonstrate that risk is increasing every year and markets need more than investors’ liquidity to support them. It’s also becoming clear that stocks no longer trade on company fundamentals, valuations, price-earnings ratios, and earnings growth which had a major impact on investment decisions in the past but are now more irrelevant than ever.
In the modern financial world, liquidity is the new king of global stock market sentiment, and, at some point, markets will have to face the reversal of the risk parity trade that has caused an epic rise in stock prices over the past few months.
Judgment day in 2020 will be the central banks deciding — once again — to turn off the credit taps and tighten liquidity by becoming overconfident in the market’s ability to support itself without regular interventionism. When that day comes, anyone hoping to invest in the future will want to know the answer to the following question: If central banks are no longer supporting asset prices then who is?