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Central banks: a safety net for investors

At the beginning of June, the S&P 500 and the S&P/TSX were up nearly 15%. This performance was achieved despite a number of destabilizing factors in the first half of the year, including the following:

  • The United States broke off negotiations with China and raised punitive tariffs to 25% on some $200 billion in annual Chinese imports;1
  • In an attempt to reduce illegal immigration from Mexico, Donald Trump threatened to impose 5% tariffs on all Mexican imports;2
  • Canada’s gross domestic product (GDP) grew by 0.4% (annualized) in the first quarter, falling significantly short of analysts’ forecasts (+0.9%);3
  • The German Manufacturing Purchasing Managers' Index (PMI) remained below 50, indicating a contraction of economic activity;4
  • Chinese exports were down by more than 20% in February 2019, a worrying signal for the economic health of the Asian giant.5

What we can learn from the “invisible gorilla” experiment

Considering all the factors listed above, how do we account for the impressive performance achieved by the benchmark indexes so far in 2019? Before answering this question, it’s worth examining the findings of a very interesting experiment that was conducted by cognitive psychology researchers Christopher Chabris and Daniel Simons from Harvard University6.

The researchers got participants to watch a video of people playing basketball and instructed them to count of the number of passes made by those people who were wearing white shirts. While the majority of participants got the answer right, only half of them noticed that a person wearing a gorilla costume walked through the scene—and even beat his chest!

According to Chabris and Simons, the “invisible gorilla” experiment demonstrates that when our brain is focused on one type of information, it tends to ignore other relevant information, even when it’s plainly in sight, due to a process called “selective attention”. Returning to our analysis, our attention has been focused on the actions and policies of Donald Trump, and we’re particularly attentive to data that points to a slowdown in the global economy. However, we may fail to account for the reason behind the markets’ substantial upswing this year, namely the monetary policy of the US Federal Reserve (the Fed).

Low interest rates favour equities

In response to the worsening geopolitical and economic environment, the Fed has reaffirmed its willingness to take action by lowering key interest rates, a move that has reassured the financial community. According to the CME FedWatch Tool, on June 7, investors believed there was a 35% likelihood that the Fed would slash interest rates three times to 1.5% by the end of the year7 from its current 2.5%. As you are aware, a lower interest rate environment leads to more favourable mortgage rates, stimulates investment and, most crucially, revives investor appetite for riskier assets such as equities.

Nowadays economic cycles are increasingly longer in duration, and central banks have a lot to do with this. For example, the average duration between recessions has been eight years over the last five decades, compared to just two years in the 19th century8. Furthermore, the last recession in the United States was more than a decade ago. In Australia, a recession hasn’t been seen in 28 years! As a result, many investors are convinced that central banks will be capable of preventing a global recession by using accommodative monetary policy; that is, by cutting interest rates.

After achieving excellent returns for over a decade, it’s reasonable to be skeptical whether such an excellent performance can be repeated in the future. At the same time, we should never underestimate the influence of central banks: the ultimate safety net for investors!

Sources:

Agence France-Presse (2019). Canada : hausse du PIB de 0,4 % au 1er trimestre 2019. Les Affaires.com. This link will open in a new tab. https://www.lesaffaires.com/secteurs-d-activite/general/canada-hausse-du-pib-de-04-au-1er-trimestre-2019/610647. Retrieved June 2019.

Agence France-Presse (2019). Face à l’afflux de clandestins, Trump emploie les grands moyens contre le Mexique, le Journal de Montréal. This link will open in a new tab. https://www.journaldemontreal.com/2019/05/30/immigration-clandestine-washington-va-imposer-des-tarifs-douaniers-au-mexique. Retrieved June 2019.

Chabris, C. and Simons, D. (1999). The Invisible Gorilla. This link will open in a new tab. http://www.theinvisiblegorilla.com/gorilla_experiment.html. Retrieved June 2019.

CME Group (2019). CME FedWatch Tool. This link will open in a new tab. https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html. Retrieved June 2019.

Ehret, L. and Girault, J. (2019). Chine : les exportations s’effondrent de 21 % en février, regain d’inquiétude sur l’économie. La Presse. This link will open in a new tab. https://www.lapresse.ca/affaires/economie/international/201903/08/01-5217503-chine-les-exportations-seffondrent-de-21-en-fevrier-regain-dinquietude-sur-leconomie.php. Retrieved June 2019.

Ehret, L. and Ricci, S. (2019). La Chine réplique aux États-Unis avec des droits de douane punitifs. TVA Nouvelles. This link will open in a new tab. https://www.tvanouvelles.ca/2019/05/13/la-chine-va-augmenter-les-droits-de-douane-sur-60-g-de-produits-americains. Retrieved June 2019.

Housel, M. (2019). Recessions: It’s Been A While. Collaborative Fund. This link will open in a new tab. https://www.collaborativefund.com/blog/its-been-a-while/. Retrieved June 2019.

Trading Economics. Germany Manufacturing PMI. This link will open in a new tab. https://tradingeconomics.com/germany/manufacturing-pmi. Retrieved June 2019.

1Ehret et Ricci (2019)

2Agence France-Presse (2019)

3Agence France-Presse (2019)

4Trading Economics (2019)

5Ehret et Girault (2019)

6Chabris et Simons (1999)

7CME Group (2019)

8Housel (2019)

The author

Michel Villa

Michel Villa

Speaker, stock market blogger and trading coach