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Global central bank policy after the 2008 financial crisis and the 2011 euro crisis has been analyzed in hundreds of books and by brilliant economists. The focus here is not on whether it was the right thing to do or could have been done better but on the effect quantitative easing and low rates has had on companies and investment managers' ability to outperform the market.

Global central banks have been actively involved in fueling the developed world economies (US, Europe, and Japan) for the past decade at a level that has never been seen before in history. The Federal Reserve (Fed), European Central Bank (ECB), and Bank of Japan (BoJ) have not worked in exact coordination, but they have followed similar paths. The effect has been that global central banks have been the number one driver of equity markets. The age-old maxim “Don't fight the Fed” has never been more apt than in recent history. US Federal Reserve governors are the new investment rock stars driving financial valuations to historic highs in the 2010s. Central banks globally have succeeded in lowering rates, ensuring credit accessibility, and raising the value of all financial assets without growth in inflation to date. Figure 2.1 depicts the growth in central bank assets of each of the three major developed world central banks in trillions of US dollars.

The magnitude of the asset growth is over 300% since 2007, and globally central banks have purchased over $15 trillion in assets, while GDP growth around the world has been stagnate. Each time one of the central banks has tried to ease off there has been a recessionary scare and they have jumped back in to support a fragile global economy. You can see by the solid line that the US has tried since 2015 to wean itself off the Federal Reserve support system, but as of the fourth quarter of 2019 slow growth and low inflation has the Federal Reserve once again supporting the markets with expected rate cuts and an increase in assets. Back in 2008, no one would have predicted that ten years after the 2008 financial crisis global central banks would hold this level of assets.

FIGURE 2.1 Global central bank assets—US Fed, Bank of Japan, and European Central Bank (2002 to November 2019)

Europe and Japan have not even attempted to slow levels of monetary support. Sovereign rates in these countries have been pushed into negative territory through the magnitude of central bank intervention, a feat that most investors and academics never thought could happen. In November 2019, an investor expected to pay the German government 0.35% and the Japanese government 0.15% to lend the government money for ten years. The ECB holds close to 20% of the sovereign debt of EU countries and has been buying as much as 90% of new issuance in certain months. Paying to lend a country money (buying sovereign bonds) or anyone for that matter does not make economic sense and blows up traditional quantitative models and risk analyses; yet is becoming a normal occurrence in developed world sovereign markets.

The Bank of Japan holds over 50% of all Japan sovereign debt outstanding and has led the quantitative easing experiment by also buying corporate bonds and equity ETFs. The BoJ began buying equity ETFs in 2010 to support the country's equity markets after the financial crisis. It continues to support the equity markets ten years later. In the years 2017, 2018, and 2019 the Japanese central bank bought an average of $50 billion of Japanese equity ETFs each year in an attempt to support the country's equity markets. In 2018, the balance sheet of the BoJ surpassed the country's GDP. The BoJ holds over $5 trillion in Japanese financial assets. The buying is not only unprecedented but also not sustainable.

Central banks would like to raise rates and return to some semblance of a normal rate environment, but they are up against two forces that are proving difficult. Inflation has been below normal levels despite zero percent rates, high asset prices, and large amounts of liquidity and capital in the economy. Globalization provided cheap labor and a large portion of the manufacturing base in the US and Europe moved overseas in the new century. This trend lowered prices and had a dampening effect on inflation. By 2015, the globalization trend had matured, but technology and demographics are now acting as key inflation-dampening forces. The US and Europe are debtor nations, and inflating away debt is the easiest and most comfortable path for debtors. Deflation would be a major problem for both government and consumer debt obligations. The Federal Reserve and all global central banks are very aware of the perils of deflation and the need for inflation. Even if the economy is growing nicely and unemployment levels are low, it would be difficult for central banks to return to historic interest rate levels, if inflation were not to move above 2.0%

History is inflationary; governments promise more than they can provide and they never want voters' assets to be worth less than before.

—Will Durant, historian

Unfortunately, developed economies are not growing at historic rates, if at all. This is another key driver that keeps central banks from raising rates. Neither Europe nor Japan is showing enough growth to even consider lowering support. Eurozone GDP growth has not hit 2.5% since before 2010 and future expectations are anemic at 1% to 2%. Japan has been even worse despite larger levels of support from the Bank of Japan. Growth rates in the developed world as a whole have been below 2% on average since 2010 and are forecasted to stay at these historically low levels.

So a lack of growth and inflation despite historically high levels of asset buying and low rates keeps the central banks from raising rates. Interest rates have remained below 2% globally with Europe and Japan rates below zero. Any time investors perceive rates to be rising they flee the markets and growth slows even further forcing global banks to reconsider any rate raises. This is a rate environment that was never anticipated, especially with US unemployment levels below 4% and the US stock market reaching all-time highs (3,100+ on the S&P 500 in November 2019). There is no historic data on this level of central bank intervention, so derivative effects are not known in the intermediate or long term. Despite (or because of) this, equity and bond markets remain unperturbed, demonstrating the lowest volatility levels in history. The 2010s will be remembered for central bank intervention driving the lowest rates in history and the equity markets demonstrating the lowest levels of volatility.

[On 0% interest rates] I can't figure out how it's going to end. I just know it's going to end badly.

—Stanley Druckenmiller, investor

Can central banks unwind their asset purchases over the next decade?

A complete unwind or a return to central bank asset levels pre-2008 will either never take place or at least not occur for decades. There is no way that the Fed, ECB, and BOJ can sell a majority of their assets back into the market in any intermediate time frame.

[In July 2014] I hope we can all agree that once-in-a-century emergency measures are no longer necessary five years into an economic recovery.

—Stanley Druckenmiller, investor

Not unwinding the central bank asset growth does not mean rates will always be close to zero, but historical interest rate levels will not be seen for many years. Looking at the 20-year history of the Federal Funds rate in Figure 2.2, rates have been 4%, 5%, and even 6% at certain periods. A Federal Funds rate at 5% is impossible to imagine today. The hope central bankers hold is that a small amount of growth in GDP and inflation over many years, while holding assets flat, can right size their balance sheet. Federal Reserve increases in 2016 and 2017 were quickly reversed as the economy demonstrated its fragility and capital markets started to drop.

If the central banks can simply maintain assets at $15 trillion, potentially the developed world economies can grow (and inflate) into a scenario where $15 trillion does not look that extreme. It is a delicately balanced scale. Investors have remained confident and taken on more risk, and to date the US Federal Reserve has maintained continual support of the markets.

Inflating the value of financial assets has been the one goal that the Fed has been able to master. Low rates and promises to promote growth at any cost has supported financial markets and consumer confidence in general, but it has had a derivative effect. Financial asset growth has created the greatest wealth divide since the 1920s. If you own financial assets, you are prosperous and if you do not own financial assets you have been left behind. Figure 2.3 shows a graph of the S&P 500 and the Federal Reserve assets since 2001. It would be hard to dispute the causation of Fed intervention and equity performance. The Fed tried to raise rates in 2017 and 2018, because unemployment dropped below 5% and the economy seemed to be expanding, but the equity markets stalled, scaring the Fed into cutting rates once again in 2019 and renewing asset growth.

FIGURE 2.2 US Federal Funds rate (1998 to November 2019)

FIGURE 2.3 Federal Reserve assets and the S&P 500 Index (2001 to November 2019)