- Returns for global stocks have shown a strong correlation with central bank asset purchases over the past decade.
- Central bank asset purchases are about to plummet.
- Nobody’s really sure what’s going to happen next, because it’s an unprecedented situation.
“Correlation does not imply causation” is a vital principle of statistics and numerical models which reminds us that just because two things correlate doesn’t mean one causes the other.
For many investors, they’ll be hoping that the correlation shown in the chart below is not a sign for things to come for stock market returns.
Because if this correlation holds, things could be about to get nasty.
The chart, from Citi, shows the rolling annual change in central bank asset purchases overlaid against annual returns for the MSCI World Stock Market Index since the depths of the global financial crisis back in early 2009.
Clearly, as asset purchase levels have changed, so too has the performance of global stocks, tending to rise when asset purchases increase and fall when asset purchases decline.
Until recently that is.
As shown in the red circle on the chart, despite a recent deceleration in central bank purchases, stock market returns have actually increased recently, bucking the trend seen over much of the past nine years.
“In a world where the global CB taper is well underway — and in any case largely announced — stocks are seemingly starting to decouple from the bearish implication of [the chart],” says Citi.
“As we had hoped, in a strong cyclical backdrop, with earnings coming in strong, markets can focus on underlying fundamentals rather than the reduction in central bank accommodation.”
Central bank asset purchases set to slow sharply over the next year, as seen in the dotted black line in the chart.
If the relationship between asset purchases and stock market returns were to snap back into place, it suggests that stocks could fall by close to 50% over the next year or so.
To be clear, Citi isn’t saying that’s going to happen, but it is a reminder that we’re entering uncharted territory for financial markets.
Ultra-easy monetary policy settings are slowly being reversed, and no one is really certain as to how it will all play out.
Adding to the intrigue, it’s clear from this other chart from Citi that while stocks recently disconnected from central bank asset purchases, corporate credit markets have not, with spread compression in investment grade debt starting to reverse in line with lower asset purchases.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.