Perspective on Risk - May 14, 2022 (Liquidity)
Recap; CrossBorder Capital’s Analysis; So What Are They Saying Now? If You Prefer Watching & Listening; Something Always Breaks
If you been following for a while, I’ve had a couple of posts that try and look at the ‘liquidity-driven markets.’ Here are a couple of links:
Recap
In the first of those posts I wrote about David Merkel’s Aleph blog post Estimating Future Stock Returns where his model seems to outperform CAPE when estimating 10 year forward nominal total returns. The Aleph model posits that forward returns are negatively correlated with the current % that investors hold in equities.
I tried to expand his model by jointly looking at CAPE and his money flow statistics and came up with a marginally better r-squared.
Back then we asked, and answered, the question posed in my last blog: what, historically, has been the market P/E when inflation has been above 5% and real yields negative?
Research Affiliates looked at this in King of the Mountain: Shiller PE and Macroeconomic Conditions. It’s ugly.
Lastly, we linked to Lunch at the Club - Mike Green. He discusses the impact of passive investments on markets.
You may want to revisit that post before continuing.
Frederik Gieschen points us to a useful thought from Keynes.
CrossBorder Capital’s Analysis
While not identical to the Merkel work, or my prior regressions, Michael Howell’s1 CrossBorder Capital blog’s somewhat regularly using the same essential hypothesis: liquidity drives price levels. Here is a link to a paper describing their liquidity indices. Their Global Liquidity Index includes weighted components for central bank liquidity, private sector liquidity, cross-border flows, and financial conditions. Their principle resource describing their approach appears to be Capital Wars - The Rise of Global Liquidity (note: ordered but haven’t read). They don’t give a breakout of what they use, but it’s pretty clear that they are using publicly available statistics from Flow of Funds and other Fed reports. It seems like the kind of geeky inside-baseball stuff that we like. Michael is certainly knowledgeable and known in the market.
They assert a causal link between their GLI and financial and economic variables:
Using Granger Causality Tests, the GLI tend to lead financial variables by 6 – 9 months (average 7.6 months) and economic variables by 12 – 15 months (average 13.2 months).
Foreign Exchange Rates – the ‘price of money’ responds to the difference between the private sector liquidity index and the Central Bank liquidity index, with a lag of around 3-6 months.
Fixed Income Spreads – the quality spread and the time spread (yield curve) respond to Total Liquidity (Central Bank plus private sector plus cross-border)
Equity Market P/Es (Valuations) – equity valuations move closely with bond markets and the yield curve. Hence, like bonds they move closely with Liquidity Momentum with a lag of 3-6 months. The yield curve also determines the split between value and growth stocks, and between defensive and cyclical stocks.
Equity Market Earnings – the level of Total Liquidity determines the pace of business activity around 12-15 months later. Given that it takes, on average 3-6 months for companies to report profits to shareholders, this means that liquidity leads the reported earnings cycle by around 15-18 months. Taken together with the lead-time for P/Es, equities overall tend to follow liquidity with a 6-12 month lag.
Investor Exposure – we collect data on actual investor portfolio exposure to equities, bonds and liquid assets. We take normalised z-scores of this data to derive Sentiment Indexes. These are useful short-term momentum indicators and longer-term contrarian indicators.
Point 5 seems quite analogous to what Merkel’s work sought to use.
They claim their data is useful for risk officers:
We apply our liquidity data to measure liquidity and exposure risk and produce indexes specifically designed for risk officers. AIFMD and UCITS IV, for the first time, now require liquidity risk to be explicitly addressed.
I haven’t verified any of this so buyer-beware.
For fun, I scrolled back to read their posts from Jan-Feb 2022. They did note:
Unless the spiral is broken by higher interest rates, global liquidity will ultimately bound higher. At the same time, asset allocation has been put on a potentially self-destructive autopilot that ignores sensible investment criteria, so that money is focused on the largest stocks, driving their valuations and sometimes even their owners towards the moon. The liquidity threat looming over markets in 2022 (January FT)
Latest inflation trends pushing policy-makers to a still sharper monetary squeeze. US Fed is not only behind the curve on inflation, they are also ‘behind the crowd’ in terms of policy tightening (Feb 2022 report)
So What Are They Saying Now?
This seems consistent with our estimates from the last PoR. Another 15-20% down over 12-18 months. Or not. What do I know.
If You Prefer Watching & Listening
Some of you prefer to watch Youtube videos or listen to podcasts; here are links to a recent interview he did with the Forward Guidance podcast. The Youtube presentation has a few useful slides that you will have to imagine if you listen to the podcast.
Something Always Breaks
Now, from a risk manager perspective, paraphrasing buffet, in a few months we ought to see who’s swimming naked, and what the weakest part of the financial infrastructures is. Something always breaks.
Six months from now, perhaps sooner, we will again be worrying about the ‘wall of refinancing’ that is to come, and we will see an increased demand for the safe asset (UST). This later demand will play out in reduced demand for the Fed’s RRP facility (I think); I await Zoltan’s more cogent thoughts.
What will the break be this time? The fun thing is that we really don’t know what will be ‘the-big-new-problem.’ The core of the financial system seems well-capitalized, and the extent of shadow-banking has been brought under control.
Clearly crypto is fragile and not systemically significant enough nor tied to the real-world financial system to matter.2 The Tether stablecoin is in trouble.
Collateralized lending into reduced liquidity will likely face higher margin requirements. Office CRE seems particularly vulnerable, and does the recent trend of lending against intangible assets.
There has also been a notable increase in lower-rated below-IG credits. Many firms that otherwise would not be viable have likely been holding on due to a Fed-subsidized low cost of capital. Maybe, just maybe, we’ll be in for an old-fashioned credit cycle!3
While not a Treasurer, I put Michael into my ‘hairy eyeball’ experience category.
As a diversion, I give you a quick TikTok: Crypto, boy
Kevin and I can only hope.