Now may be a good time to remember the global panic that struck in early 2016.
The latest economic growth and market strength formed their roots then. Recall that in late 2015 investors began to notice warning signs in China about its seemingly overheating market at the time.
China’s stock markets had a very strong 2015, in large part due to its regulators changing the rules to allow more leveraged investing. As 2015 turned into 2016, the markets went from extended into bubble territory.
Then the bubble burst. Once the markets began to plunge, the leverage accelerated the fall. The rapid stock market decline, combined with worse-than-expected economic data, raised concerns. Since China had propelled much of global growth since 2009, there were significant worries about the fate of the global economy.
Data from the United States and other developed nations also fell below expectations. Fears rose that the global economy was on the verge of deflation, which could lead to a new depression. All markets began rapid declines, except government bond markets, which gained from a flight to safety.
The world’s central banks responded with strong monetary and credit growth. Most measures of monetary policy showed notable expansion in early 2016 during what appeared to be a coordinated global policy.
The moves succeeded.
Global stock markets and commodity markets recovered. We’ve gone from talk of deflation in early 2016 to the current time when inflation rates nearing central bank targets and talk of reflation.
In late 2016, the Federal Reserve resumed the tightening it began in 2014, when it stopped quantitative easing, and made clear it plans to continue tightening through 2017. The European Central Bank continues its quantitative easing but indicated it might shift to a neutral monetary policy in late 2017 or early 2018.
It appears that in the United States and in emerging markets, economic activity has produced enough momentum that growth can continue with neutral or mild tightening of monetary policy.
In my view, markets don’t recognize the momentum in the global economy. They’re probably overestimating growth in the United States, but they are underestimating the likely growth in Europe, emerging markets and Japan. That’s where we’ve taken the bulk of our risk in the Retirement Watch portfolios, and it’s paid off.
Of course, we have to worry about what’s next.
The greatest risk, as I’ve said many times, is that central banks might tighten too much, too fast. That’s still possible, but public statements indicate the central bankers understand this risk and are determined to err on the side of too much easing rather than too much tightening.
Another risk is that the momentum isn’t as strong as it appears. Perhaps growth can’t be sustained in the face of mild tightening. I don’t think that’s the case, but it is possible that a shock or shocks, combined with mild tightening, may puncture economic growth. These potential risks are why we look for margins of safety in our investments and balance and diversification in our portfolios.
— Bob Carlson