Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online. Subscribe to Globe Unlimited at globeandmail.com/globeunlimited.
My pick for the most important chart for 2018 is an all or nothing proposition. It either matters a lot, and investors across the world are in for a very difficult year, or it doesn't matter at all and this is the last time you'll see anything like it.
Whatever happens, the chart should answer the important question as to how much of the market rally – accompanied by allegations of asset bubbles – has been the result of easy central-bank monetary policy.
The accompanying two charts are originally the work of British-based Citigroup credit strategist Matt King. The lower chart is the main one, and I want to acknowledge the help of Mr. King and his team in providing the necessary data.
Mr. King's bearish view is based on two premises. The first is that the effects of major central-bank monetary stimulus are not confined to the country of origin – they affect all global markets. A Canadian investor who feels the wealth effect from the rising value of his or her home, and purchases a U.S. technology stock, is an example of how monetary policy constantly bleeds across borders.
As part of the same theme, Japanese and Chinese investors buy U.S. Treasury bonds with excess investment funds that result from Bank of Japan and People's Bank of China monetary policy of asset purchases and credit creation.
Mr. King was among the first analysts to emphasize the global market effects of central banks. In a Nov. 20 report, he writes that, while most economists believe a strengthening global economy is behind recent market strength, "we think there is another explanation which fits much better … central banks, through their global asset purchases, have been far more effective than they realize at lifting global asset prices by crowding investors into risky assets, distorting traditional valuation metrics in the process."
The top chart underscores this by showing central-bank asset purchases since 2010. Different banks have been more active at different times, but the cross-border nature of investment flows implies that it's the combined total of global stimulus that matters most for markets.
Now we come to the main event: The lower chart plots the three-month change in central-bank market purchases against the three-month change in the MSCI world equity index, suggesting that aggregate central-bank activity is driving global equity values.
Importantly, the extent to which the two lines on the chart move together is not consistently high through the chart. There are periods – between January, 2015, and June, 2017, for instance – where a close relationship is apparent. There are other times – such as late 2012 to early 2013 – where there seems to be little connection between equity returns and central banks at all.
In general, however, there is enough here to take seriously Mr. King's argument that central banks have been an important determinant of equity returns.
For 2018, equity investors will be hoping Mr. King is wrong about all of this because central bank support of markets is set to decline sharply. The U.S. Federal Reserve announced in September that it would begin "unwinding" its giant balance sheet, allowing existing fixed income holdings to mature without purchasing more assets to replace them.
In addition, the European Central Bank warned markets that it would cut its monthly open market asset purchases in half, to €30-billion ($45-billion) from €60-billion a month.
These policy changes combined will almost certainly send the purple line in our second chart lower, and if Mr. King is right about the importance of central banks in equity returns, the MSCI world index will fall as well.
Charges that the continiuing global bull market in bonds and equities is "fake," and just a huge asset bubble caused solely by loose monetary policy and central-bank market manipulation, have been around since the financial crisis ended. The reason I've chosen Mr. King's chart as the most important for investors is that, in 2018, we might be able to use it to find out once and for all if these fears are grounded or not.