Note: Although posted on or about 9/15/24, this blog was actually drafted in February 2024 before the blog originated. I thought the timeliness and relevancy of the subject matter were important enough to see the light of day on "Mark's Macro Musings."
Like many active investors who closely follow the capital markets, I fully expected the American economy to enter a recession in 2023 with a corresponding dive in the stock market. The most expected recession in history never arrived in 2023 and the S&P 500 Index appreciated by 24% last year (2023).What the heck happened? In my opinion, there were two primary reasons for this surprise. The first one, and by far the least important of the two, is the customary lag period (6mo.-18mo.) between interest rate changes and their impact on the economy. The Fed Funds rate went up by 5.00% between March 2022 and year-end 2023. A significant increase with seemingly little effect on the economy. There is another factor that trumps interest rates - liquidity. While interest rate levels capture most, if not all, of the attention, the real story of liquidity levels escaped the scrutiny of almost everybody. This is a mistake, a profound one.
Before proceeding, it would be wise to establish a definition for liquidity when used in the context of the financial markets. Liquidity would be a combination of all liquid assets and the availability of credit to borrowers. Liquid assets are further defined as all such assets that can be exchanged for money, at any time, at short notice, and at a relatively small transaction cost. Obtaining credit or having debt is self-explanatory. It should be noted that the debt portion of the equation is probably more important in the determination of market liquidity. The credit availability factor is also more volatile and usually the source of financial crises.
We live in a credit-based world - leverage is what drives the boom-bust cycle and liquidity sets the stage for the debt cycle. When leverage is cheap (low interest rates), people borrow profusely and bid up riskier assets - pushing prices higher (the boom phase). Following the Great Financial Crisis in 2007-2009, the Federal Reserve Bank effectively adopted a program of keeping interest rates artificially low and flooded the system with monies via Quantitative Easing (QE). Those monetary stimulants went into hyperdrive when the Covid-19 pandemic hit in 2020. The result is that the Fed has managed to simultaneously drive debt (government, corporate, individual) levels to historic highs while creating a massive asset bubble, particularly in the equity and real estate markets.
The flip side of the boom phase is of course the bust phase. When leverage is expensive (higher interest rates), people borrow less - and even liquidate riskier assets to pay back debts - pushing asset values lower. As mentioned previously, the Fed started aggressively raising interest rates in March 2022. Late in 2023, they effectively pivoted with indications that either in the 1st Quarter or 2nd Quarter of 2024, they would begin reducing interest rates. Starting in June 2022, the Fed began gradually reducing its Balance Sheet via Quantitative Tightening (QT). This will no doubt come to an end at some point in 2024 since they have messaged rate cuts are coming in 2024.
Ironically, despite the Fed's rate hikes and Quantitative Tightening over practically two years, monetary conditions are still considered "loose." The reasons are multiple. Banks still had trillions worth of excess reserves from the Fed's QE years. Plus, slowing growth and calamity in Europe, Emerging Markets, and Asian economies have pushed investors to put cash in the United States. The U.S. and U.S. dollar is still considered a safe haven for parking money. This has given banks even more excess money.
By this point, the reader is probably thinking..."Now where can I find information and data concerning the present and past liquidity levels?" The ideal mechanism to track and measure liquidity in the financial system is the National Financial Conditions Index (NFCI). The NFCI tracks what is going on in money, debt, equity markets, and even the "shadow banking" system. This information and valuable tool is generated and posted by the Chicago Federal Reserve Bank. The index is neutral at zero. A number below zero is considered "loose" conditions. The more below zero, the "looser." A number above zero is considered "tight" conditions. The more above zero, the "tighter." When the NFCI has spiked dramatically above zero, harsh bear markets and economic recessions have occurred.
It is only a matter of time before another leak springs in the financial system due to unprecedented (500 basis points) interest rate increases in the past couple of years. A little under a year ago the Fed had to extinguish a fire when regional banks such as Silicon Valley Bank and First Republic Bank imploded. A strong candidate for the next potential crisis would be the corporate debt sector. Corporate debt as a share of GDP is now at an all-time high. Firms took advantage of the ample liquidity and low rates to bring on debt. Approximately 40% of the companies in the Russell 2000 are losing money. These are companies that rely on credit to stay afloat. Over the next 2-3 years, a whopping $3.5 trillion of corporate bonds are set to mature. Companies will be forced to roll over debt and add new debt when the cost to borrow will no doubt be much higher. Markets will be in a fragile position if liquidity dries up.
In the process of reading a book and various articles on the subject matter of this blog, I stumbled upon a statistic that switched on a light bulb in the cognitive portion of my brain. Per an economist and author named Michael Howell, over the past 40 years, new factors have evolved to displace earnings power as the main driver of stock prices. He goes on to postulate that only about 20% of equity gains can be attributed to increased corporate earnings. I assume that figure is net of inflation -which was up a little over 200% between 1982 and 2023. The S&P 500 Index, on the other hand, increased by a mind-boggling 3,300% (from 140.64 to 4,769.83) between 1982 and 2023. So why did investors move away from safe assets like bonds and seek riskier assets like equities? A strong argument can be made that enhanced and elevated global liquidity is the answer.
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