Markets Fighting Dramatic Reduction in Liquidity

Based on this week’s Congressional testimony by Chairman Powell, the Fed is still sticking with plans for tightening policy even as the outlooks for markets and economies become more tenuous.  Central bankers across the globe are mostly reversing QE policies with increasing speed on the hope that markets allow them the cushion to make the bet that monetary normalization is in order. We still suspect the overwhelming amount of global debt and a shortage of U.S. dollars will soon frustrate those efforts.  The trauma in emerging markets and the worsening downward spiral in China seem to make this likely.

New tariffs out of the White House add some marginal inflation risks to this delicate balance, though we do favor efforts at improving trade terms for U.S. companies.  It’s important to remember that numerous intermediate goods from U.S. companies’ overseas operations are counted as imports, although the same companies ultimately assemble and sell the resulting end products here and elsewhere. That’s a long-winded way of saying any trade balance remedies are complicated.  China is clearly letting the yuan decline to counter the impact of tariffs, so this battle will be tough to win without some pain on both sides.

Looking at the U.S. in isolation is a mistake.  We may be doing better than most, but it’s important to remember that our economy is profoundly interlinked with others by a global dollar addiction that was created by the Fed.  Now, Quantitative Tightening, because it shrinks the supply of dollars, means international lending is under severe pressure.  That is a powerful deflationary and anti-growth force.

By one count, only about $75 billion of net QE took place between the major central banks in the first half of 2018 versus over $700 billion in the prior six months.  With the overall move clearly in the direction of central bank balance sheet shrinkage, it will not be long before, for the first time since 2008, liquidity provided to the financial system by monetary policy will turn negative.  That is significant.

It is not as though the debt growth is not still going gangbusters globally.  In the first quarter, according to the IIF, global debt grew by $8 trillion to $247 trillion or 318% of the world’s GDP. It will get tougher to keep up this pace when central banks are no longer in the bond buying game.  Also, credit measures are stretched, so some lenders are beginning to become more selective.  Defaults in China are becoming an issue.  Debt is simply future demand brought forward in time, so this rapid pace of borrowing does not bode well for future GDP growth.

It seems that about the only major stock buyers remaining are companies themselves as ETF flows into equities have slowed dramatically.  A rather large short-covering trade was a powerful spring phenomenon that helped stocks.  Corporate tax cuts that were supposed to be used for capital expenditures are, not surprisingly, being used mostly to fund corporate purchases of their own equities.  However, those buybacks are no longer helping to boost stock prices according to some recent data.

Many investors are still choosing to maintain overall exposures to stocks with what have been classified as a shrinking list of winning bets and selling almost everything else.  For now, it seems emerging market stocks and bonds in particular and non-U.S. equities more broadly are facing the most pressure.  Recently, once popular financial stocks and investment grade corporate bonds are also facing strains as credit worries surface.  The degree of tech and growth stocks outperformance this year seems to be a quite unsustainable and desperate attempt to maintain market momentum.

Six companies represent 17% of the S&P 500’s market cap and trade at a combined 88 times trailing earnings.  That looks like the same sort of massive distortion we have seen in the prior two cycles.  Like those earlier periods, these companies might continue to do quite well over the years yet see their stocks collapse by 50% or more as the environment changes.

It seems more highfliers are crashing to earth.  Bitcoin lost 70% of its value after a period of extremely euphoric sentiment.  Theranos has been exposed as a scam, costing some sophisticated players large chunks of money in the process. GE has fallen 60%.  It is one of the most highly followed stocks on the planet.

Other securities have yet to correct mis-pricings.  Teslas are neat, but we can’t understand how one can arrive at a $55 billion equity market cap when the credit picture is quite cloudy to us.  Netflix attracts customers without producing cash flows commensurate with its $170 billion market cap that nears that of entrenched players with much better earnings yields and strong competitive advantages including more content.

We continue to expect corporate credit spreads to widen further as bondholders become much more discerning.  This will likely prove to be the fly in the ointment for this cycle. The problem is that the global economy never hit escape velocity after ten years of massive central bank support which fostered the creation of trillions of dollars of debt that must now be serviced without a sustainable platform for future growth.

Fixing a debt problem with ridiculous amounts of additional debt was never going to work, but it enabled the fantasy that a lack of income growth could be overcome with another lending binge to continue.  Now the inflation data is forcing the Fed’s hand more than it has in a while, so it will be tougher to change the current tightening course.

Central banks have almost killed the risk discount mechanism with their constant interference.  Those with ten years of experience in markets can only imagine how differently markets can act when risk is not socialized.  However, if current monetary plans come to fruition, a pronounced re-pricing of risk could take place as those who treat this financial landscape façade as a sustainable foundation for investment and business planning are forced to re-evaluate exposures in a world where cash yields 2%, not 0%, and liquidity is declining.

Even a return to the level of monetary coddling prior to 2008, which was already extremely easy, would seem like the Fed has turned harshly against investors.  The last ten years is that reckless and unusual.  It was not just the opening of the Pandora’s box of QE in a massive way.  We also saw the Fed step into the mortgage securities market, the ECB buy corporate bonds, and the BOJ purchase stocks.

It does not take much imagination or even foresight to have concerns.  It’s important to remember that moderately severe market disruptions took place in the last five years when liquidity tightened just marginally and investors simply lost faith that central bankers would come to the rescue.  2016 is not that long ago.

The current policy change is a dramatic reduction in liquidity that has never been tried before in the history of financial markets and it appears for now that risks are being re-evaluated.  While we suspect the central bankers will revert to easier policies if market pain becomes severe, we don’t think it’s before equities have been more broadly re-priced.  At the same time, as we learned in the last decade, they can’t prevent the entirety of the downside of the credit cycle from unfolding.

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.