Market Overview [5] - What drives the financial markets?
Market Overview [5] - What drives the financial markets?
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Welcome back investors,
In this week’s Market Overview we will focus on the financial markets, how the stock market is trading at all-time highs despite the global pandemic, where the money is coming from and how much impact the central banks has on the financial markets.
Key points in today’s newsletter:
Gold standard
1971’s Nixon shock
Inflation’s influence
The risk of printing money
Before the dollar became a fiat currency, the United States used a monetary system named the gold standard. A monetary system where the standard economic currency is based on a fixed quantity of gold.
After the Second World War (1944), a system similar to a gold standard was established by the Bretton Woods Agreements. Under this system, many countries fixed their exchange rates relative to the U.S. dollar and central banks could exchange dollar holdings into gold at the official exchange rate of $35 per ounce; this option was not available to firms or individuals. All currencies linked to the dollar thereby had a fixed value in terms of gold.
But in the 1970s, when the United States had financial problems, included: rising inflation rates, rising unemployment rates, country's leaving the Bretton Woods system and an expensive war with Vietnam, the United States needed a modification in its financial system to combat these problems.
President Nixon consulted a meeting with high-ranking people of the White House and Treasury advisors, federal reserve chairman Arthur Burns and more. They came with the conclusion to abandon the gold standard and used the dollar as the main reserve currency, ending the Bretton Woods Agreement. With the dollar as a fiat currency, the central banks had the power to print (unlimited) money when the United States had to endure financial problems.
The abandoning of the gold standard in 1971 is later named the “Nixon shock”, The Nixon Shock has been widely considered to be a political success, but an economic diversity in bringing on the stagflation of the 1970s and leading to the instability of fiat currencies.
Present day
Today, with the world still in a pandemic and widespread of countries with regulations. The global stock market is trading on or near all-time highs, but how?
One of the reasons is investors are looking beyond current earnings and betting on a return to pre-pandemic growth. However, we believe one of the most impactful reason to this growth is the interference of central banks across the world.
When Covid-19 had its grip on the United States, the Federal Reserve announced a change in monetary policy and all central banks over the world followed the same approach, it took extraordinary action to stimulate the economy by lowering interest rates and quickly expanding the money supply. While their efforts succeeded in pushing the stock market to fresh record highs, one of the consequence will be undoubtedly (future) inflation.
The stock market was not the only asset that increased over the past year. Commodities experienced tremendous growth, even cryptocurrency participated in the rally, which reached a total market cap of $2.5 trillion.
If we look at the increase in money supply through the central banks balance sheets relative size to their countries gross domestic product (GDP). We found on the November 30 balance sheets of the Federal Reserve, that the European Central Bank, the Bank of Japan, and the Bank of England comprised 54.3% of the countries GDP. That is an increase from 36% at the end of 2019, in comparison with a mere 10% in 2008’s global financial crisis. This tells us there has been tremendous growth in money supply all around the world stimulating their economies.
The risk of printing money
The increase in central banks balance sheets helped push interest rates to record lows, with over $18 trillion of government debt issued at negative yields (meaning that investors would effectively have to pay for the privilege for storing their money). This forced investors into the interest of riskier assets, like bonds, stocks, or cryptocurrencies. The people who owned these assets have certainly benefited from all the printed money into the market. However, the long-term consequences of this money printing remains unknown.
An increase in the money supply is the original definition of inflation. The consequence of it is the increase in consumer prices. While many economists and financial forecasters from the 2008 global financial crisis incorrectly predicted massive consumer price inflation, there is reason to believe this time may be different.
To strengthen our believe, central banks mostly operated as a back-up for financial institutions. This way newly printed money didn’t entered the consumer economy. However, in the current financial crisis central banks provided economic stimulus to individuals and businesses directly, sending money straight to the consumer economy.
Conclusion
With the actions taken by the Federal Reserve and the central banks around the world, we are walking over the inevitable path to inflation, what will impact consumers the most in the next few years.
We believe if central banks are finally starting their tapering strategy, the stock market could pull back from its records because of the appreciation in value of the dollar.
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