Foreign central bank moves boost stocks

Allen Wisniewski

Unless someone is closely attuned to economic policy, most people do not actively follow the moves of central banks. Not that many individuals follow the actions of our Federal Reserve, and certainly even fewer follow the policies of foreign central banks.

Given that foreign central bank moves are generally not typical dinner conversation topics, I would imagine most people did not particularly notice the events of last week. We had the Chinese Central Bank lower interest rates, and just hours later the European Central Bank suggested it would take action to buy government securities.

These moves were greeted quite favorably by world financial markets. The moves took place after Japan had just taken action less than two weeks ago to try to stimulate its own weak economy. Most people are generally aware of interest rates, though not everyone may connect interest rates to Federal Reserve policy. Our Federal Reserve has had a policy of essentially zero short term rates for a number of years. This means individuals are receiving virtually no return on savings accounts or CDs.

For those who are borrowing, lower interest rates are a benefit. However, not everyone benefits equally. Individuals who have credit card balances or poor credit still face relatively high interest rates. People with good credit have reaped the benefits, as they have been able to obtain auto and mortgage loans at very favorable rates.

The moves of the foreign central banks impact the amount of money in circulation. People generally realize that if you increase the supply of something its price goes down. If there is a bumper crop of corn, its price tends to fall. Likewise, if there are more Euros are Japanese Yen in circulation, their value falls relative to the dollar.

This is one of the reasons why the dollar has been strong against certain foreign currencies recently. As has been explained in recent columns, this has allowed certain global commodities traded in dollars, such as oil to fall in price.

The U.S. economy has been gradually improving in recent years, and our policy of 0 short-term interest rates will likely come to an end next year. In many foreign countries’ economic growth has been slowing, which is why central bank policy overseas is becoming more stimulative.

The last several years the U.S. stock market has performed significantly better than most foreign markets. This is due to both our economy being stronger, but also due to the U.S. dollar appreciating against most foreign currencies. When our currency is stronger, more foreign money tends to be attracted to our markets.

Stock prices are driven by earnings, interest rates and perceptions of risk. Over long periods of time earnings ultimately drive stock prices. In the short run interest rates and changes in the risk tolerance of investors will impact stock prices more. During the last two years U.S. stock prices have risen significantly more than earnings, because investors perception of risk has fallen.

The recent moves by foreign central banks give a sign that those countries are taking action to try to stimulate their economies. Economic benefits will not occur right away, but stock markets are forward looking. Nonetheless, in many foreign countries their regulatory and fiscal policies need to improve, otherwise these actions will only provide a temporary economic boost.

Investors should realize that some of the price appreciation in the U.S. market has been driven by shorter-term events. These are a stronger U.S. dollar allowing foreign money to enter our market, and a reduction in risk tolerance among investors. These events may continue for a while longer, but it is not reasonable to expect the stock market to continue to realize double-digit gains each year.

Eventually foreign markets will do better versus the U.S. They are significantly cheaper at the moment due to their weaker economies. Of course short term is a tougher call whether foreign or domestic markets will do better. However, for the long-term investor some foreign investment is appropriate.

Allen Wisniewski has been involved in finance for more than two decades. He lives in Culver City with his family.