Stocks had their worst Christmas Eve on record. The S&P 500 was down 2.71% narrowly avoiding the accepted definition of a bear market (20% drop based on closing prices). However, on an intra-day basis the index did indeed fall into a bear market. The losses in stocks have been swift as they often are in a bear market.
Since hitting a high on September 20th, the S&P 500 is down 19.8%. With unemployment at some of the lowest levels on record, economic growth running in excess of 3%, profit growth getting a big boost from the corporate tax-cut, and interest rates still at historically low levels, why are stocks falling?
There are plenty of explanations to go around, but one that may not be getting enough airtime is the wind down of global central bank balance sheets. We have written often about the distortive (and numbing) effects of ongoing global central bank bond buying programs. See here, here, here, and here for just a couple of examples.
Markets have been under the influence of quantitative easing for much of the last decade. It is true that the Fed stopped expanding its balance sheet through asset purchases in October of 2014, but almost as soon as the Fed stopped buying, the Bank of Japan and the European Central bank stepped up their purchases offsetting any reduction on a net basis.
The Fed started to unwind its balance sheet late last year, but the early reductions were modest and entirely offset by ongoing purchases from the ECB and BOJ.
It wasn’t until October of this year, when the Fed increased the rate of monthly balance sheet reductions to $50 billion per month and the ECB reduced its monthly purchases to €15 billion per month that a true unwinding of global central bank support began.
The bad news is that if the reduction in excess liquidity is the primary factor driving equity markets lower, global central bank balance sheets are on schedule to shrink more next year than they did this year.
The good news is two-fold. After a 20% fall in stocks, at least some of the additional balance sheet reduction may already be priced in. Second, the era of distortive monetary policy that fosters misallocation, mispricing, and ultimately less productive economies looks to be behind us for now.
Jeremy Jones, CFA
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