Liquidity, equities, credit and – risk of a market correction
See below for the key links as reference points.
What does macro liquidity, equities valuations and access to credit have to do with the risk of a stock market correction (or crash), and risk of recession?
Macro liquidity is about central banks and monetary policy. Since the GFC of 2008-09, central banks led by the USA Fed and followed by the ECB have essentially printed more money, including by buying more big bonds. This has created very cheap cash in the economy that has been lent out and re-lent out at very low rates. This has averted a repeat of the 2007-08 credit crunch that causes recessions.
We would normally expect that to be inflationary but inflation as measured by CPI has not climbed like it was expected and wage growth remains elusive even with low unemployment.
An issue with increased liquidity is these massive pools of funds created are searched for yields. Safe yields are not easy to come by with the ‘risk free’ rate of treasury bonds very low and near yield curve inversion. Contrary to headlines, it isn’t yield inversions that predict recessions, it is a lack of access to credit. Corporate bonds have better yields than treasuries but these are still are at lower yields than in the past and more risk than before. So investors have gone looking and found equities.
Equities valuations is about the fundamental analysis of what equities (shares) should be priced at given the current available information and expectations for the future. When these are low, it is a buy, and when these are high, it might be a sell, or in many cases still a hold until they decline.
Equities can outpace their valuations, as is currently openly discussed is currently happening. This can be a sign of market exuberance, but also excess liquidity. When share valuations are too crazy, eventually someone will point out that the emperor has no clothes. When there is so much cash swirling about searching for yield, equities, so long as they are rising, have attracted capital since their return for risk is acceptable in t he current low bond yield environment.
However, if equities were to wobble, then we should expect sharper falls than in the past, over shorter time frames as the investors with cheap cash exit fast to preserve their capital and flock to safety of treasury bonds and other bonds to avert loss.
The “So what?” Tying this together:
- Cash in the economy has been cheap since quantitative easing and low interest rates. Central banks are reluctant to raise rates.
- If central banks raise rates, hawkish, then liquidity will dry.
- If liquidity dries, then equities will suffer a severe correction and there will be a rush to safety assets.
- If access to cheap and easy credit is restricted then risk of a recession rises. While credit flows, recessions are avoided.
- Bond rates are still too low and until there is liquidity change of winds then equities will continue to rise.
If then, so what? Be wary of how quickly the tide can turn. If central banks change their rhetoric from Dovish to Hawkish then expect volatility, and opportunity.
By Adam Atkins. Views his own. This is not financial advice, see our disclaimer.
This is not financial advice. See our disclaimer.