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Yesterday we discovered the identify of Stock Market Santa Claus. A lot of central banks around the world are bidding up stock markets by buying shares with newly created money.

It’s Christmas for investors.

The key difference is that, in the stock market, it’s Christmas all year round.

The Bank of England, due to run out of government debt to buy next year, may join the share buying party eventually too.

We closed yesterday with the question, what does this mean for you?

If central bankers can be trusted to just buy up stocks rather than letting the stock market fall, does that make stocks risk free?

Of course not!

Covid-19’s initial effect on markets in 2020, and the lack of a true bull market in the FTSE 100 since the 90s, puts that on display. There are still plenty of risks.

But the new paradigm of stock buying central banks does change the nature of investing dramatically.

Investors must think like a politician

One of the big challenges of investing these days is that you need to be right more than once to be successful. You have to be right about the financial markets and the government’s response too.

For example, a pandemic and lockdowns are likely to cause quite a bit of trouble to the economy and financial markets. You’d expect stocks to crash.

But a lot of stockmarkets are hitting new highs in 2020…

The point is, the government’s response outweighed the stock markets’ crash. Enough money was printed, spent and guaranteed to get stocks to go up.

It’s a damned impressive effort, too. It displays that investors can’t just predict crashing stocks due to the pandemic. They need to predict the government’s response in bidding stocks back up.

But how will this play out in the future – this is what investors should really be interested in.

Yesterday we examined how central bankers and governments have been desperately trying to keep stocks afloat for decades now. You could’ve summarised it with a paraphrased version of the old saying, “stock markets will go up until morale improves”.

Today, we examine what the investing industry thinks of all this…

Don’t fight the Fed

One of the most well-known investment mantras is “don’t fight the Fed”. Which basically means you should bet on central banks getting their way, especially the US’s Federal Reserve. Their budget is infinite, after all…

So, if central bankers want stocks to go up, according to the mantra, you should bet on it.

Investment bank Morgan Stanley’s Matthew Hornbach explained how his firm sees all this:

On our projections, G10 central banks will inject another US$2.8 trillion of liquidity next year – just in their government bond purchases. To put this in context, that’s more than twice the amount of liquidity central banks injected in any year prior to the one drawing to a close.

But, if our economists are right and the global economy outperforms expectations, we think the ample liquidity environment will support riskier investments to the detriment of risk-less ones.

Stocks are presumably the “riskier investments” to which he refers. In contrast to “risk-less” government bonds.

It’s worth pointing out that I’d get in trouble if I hadn’t put “risk-less” in quotation marks. After all, no investment is risk free, right…?

But let’s move on to another investment banker’s take on the flood of newly created money from central banks. And its effects on markets.

Bank of America’s Barnaby Martin wrote in European Credit Strategist that “2020 is ending with one of the most predictable and potent themes of the last decade: central bank activism.”

[…] it’s hard to escape how powerful the policy “supernova” has been this year, against a backdrop of historically horrendous growth. […] 2020 is ending with 93% of economies across the world having contracted, with 53% shrinking this year by more than 6% (versus just 17% of economies in 2009).

Despite the unprecedented global economic collapse, global stocks are trading at all-time highs…

Normally, all time highs are a time to start worrying. It’s a potential reversal point.

But if you believe central bank money printing can keep stocks going up, what is there to fear?

Quite a bit, actually.

Central bankers and politicians make mistakes. And their mistakes also unleash the opposite to stock market booms. The crashes we fear.

After Christmas comes the dreaded January…

Just as we now rely on central banks to keep financial markets ticking over, financial markets have a heart attack if their Santa doesn’t show up bearing enough gifts.

Letting Lehman Brothers fail kicked off the worst of the 2008 financial crisis, for example.

Sticking to the doomed ERM for far too long, and the stagflation of the 70s were policy mistakes too. Both involved central bank policy financing political projects. George Soros broke the Bank of England, not the government, after all.

We mentioned the taper tantrum of 2013 yesterday. Once markets are addicted to financial aid, it becomes tough to withdraw it.

The point is, just because central banks are busy buying “everything”, doesn’t mean everything is going up.

But perhaps that should be a presumptive starting point, as the industry quotes earlier seem to argue.

Which begs the question…

If a pandemic can’t sink stocks, what can?

In other words, what’s the next policy mistake which could strike stocks?

It’s not like we can predict surprises like a pandemic… and even that only sunk markets briefly.

That doesn’t mean you should presume such events don’t happen, by the way. In fact, presume the very opposite. Because they do happen. And your investment portfolios need to be robust to such events.

But if we’re asking what might go wrong for the central bank policy of bidding everything up, we can come up with some interesting conclusions.

There are a few constraints to central bankers’ extraordinary powers. One is inflation.

If the prices of consumer goods start to rise, instead of stock market prices, the central banks will be in trouble…

They’ll have to consider raising interest rates and cutting loose monetary policy, despite stock markets relying on them to go up and they must prioritise inflation, not the stock market.

We’ve already dug into how inflation might escalate out of control in past Fortune & Freedoms.

Another possibility is one I’m interviewing an expert about this Wednesday. The interview will be out around Christmas too. It’s about something called the Austrian School of Economics and how its believers see all this money printing.

To sum up for today, it looks like central bankers are hell bent on making stocks go up. And you shouldn’t fight the Fed.

But keep one eye on inflation.

And be sure to pick your stocks very, very carefully.

Nick Hubble
Editor, Fortune & Freedom