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Tide about to turn for markets as easy-money decade ends
SWEPT along by super-easy money, investors have debated for years how world markets will react when this central bank largesse ends. Now the liquidity tide is about to turn, and they have only a few months to adjust.
The world's four biggest central banks - the US Federal Reserve, European Central Bank (ECB), Bank of Japan (BOJ) and the Bank of England - have pumped US$13 trillion into the global economy since the 2009 crisis, sharply expanding their own balance sheets of financial assets.
While markets reached dizzying heights during the easy-money era, that flood will dry up by the year-end. Next year - for the first time since 2011 - the central banks are expected to suck out more cash than they pump in. The ECB will stop additional bond buying at the end of this year, and while the Fed has been shrinking its balance sheet for almost a year, it will step up the pace from October, removing US$50 billion a month from markets.
Bonds worth US$470 billion will roll off its balance sheet next year. After a near decade of money-printing and zero interest rates, the shift for markets will be momentous.
Steve Donze, senior macro strategist at Pictet Asset Management, estimates a net US$100 billion will be removed from global liquidity next year.
Central banks will go from generating half a trillion dollars this year on an annualised basis, "to zero by the end of 2018, then negative next year... a definite tipping point", making 2019 a dangerous year for financial assets, he said.
Weaning markets off the easy money may be tricky. The central bank liquidity torrent has penetrated every nook and cranny of markets, from fine wine and art to real estate, junk-rated bonds and emerging markets. It drove bond prices so high in many countries that yields turned negative and has sustained an equity bull run into its 10th year.
Cracks are already appearing in markets, already stressed by a Turkish currency crisis and trade tensions between the United States and China. Emerging equities have plunged 20 per cent since January and world stocks are set for the biggest monthly fall since March.
Average yields on junk-rated corporate dollar debt have risen 50 basis points this year.
Robust company earnings have supported Wall Street so far, but the SKEW index - which gauges the cost of put options on the S&P500 index relative to calls - signals rising unease.
SKEW is near the highest since March, showing the strength of demand for "puts", which are options that offer the chance to sell an asset in future at pre-agreed prices.
On equities, Pictet calculates that a US$1 trillion liquidity injection by the big five central banks - including the People's Bank of China - corresponds to a 20-point rise in the MSCI global index, and a similar-sized fall if the same amount is withdrawn.
Assuming a net US$100 billion liquidity loss in 2019, the index should pull back slightly.
Sunil Krishnan, head of multi-asset funds at Aviva Investors, isn't yet calling the end of the equity rally but has lightened equity and emerging market allocations. "We need to go though a period of adjusting in sentiment and valuation terms to a more mixed reality when you don't get both economic recovery and cheap money. Investors will have to adjust for that over the next few months."
Emerging markets rely more on liquidity, especially those like Turkey and South Africa, which depend on foreign capital. Among developed countries, Italy has benefited hugely from ECB stimulus, meaning its beaten-up bond markets should feel more pain.
Rick Rieder, BlackRock chief investment officer for global fixed income, said: "Any proactive reduction in the total global liquidity pool runs the risk of having a deleterious impact on a very broad set of global economies. The events in Italy of recent months highlight that dynamic."
According to consultancy CrossBorder Capital, 90 per cent of central banks now run tight policies, led by the Fed which has raised interest rates seven times. Rates rose this month in Britain too, while emerging markets are also generally tightening.
That has slowed global liquidity growth to 2.1 per cent on a three-month annualised basis from 20 per cent a year ago, CrossBorder Capital calculates.
Central bank liquidity is not the only game in town. The US tax reform is draining dollars from world markets by encouraging companies to bring home profits earned abroad; about US$300 billion was repatriated in the first quarter of 2018.
Liquidity removal could still be slow. The BOJ recently confounded expectations that it would signal a timeframe for policy tightening.
US private banks, boosted by the tax cuts, are generating US$600 billion a year in liquidity, Pictet's Mr Donze said, offsetting Fed tightening. Even the Fed might decide to move more slowly because of the trade wars and emerging market selloffs.
China has started pumping cash into its economy to ease trade-linked strains. Accelerating loan and money supply growth there could drag on global liquidity tightening. REUTERS