High and dry

The strong bull run in global equity markets coincided with high levels of liquidity. But are the recent falls in global stockmarkets a sign that liquidity is drying up? And should investors be concerned? Sunil Jagtiani reports.

Investors are on red alert. IFour years into an unexpectedly strong bull run in shares, substantial stockmarket losses have raised fears that the equity market party is over. One reason why it might be right to be cautious, according to some analysts, is a turnaround in global liquidity conditions – a development that could portend more stockmarket volatility and share price falls.

It is unsurprising that investors are concerned about future returns, given the extent of the sell-off in the world’s stockmarkets in May – the MSCI World index tumbled nearly 8% in just over two weeks – and earlier evidence of financial market stress in peripheral investment regions (see box below).

The jury is out as to whether the slide is a buying opportunity, which proved to be the case with previous sell-offs in the bull market since 2003. But there is anecdotal evidence of greater nervousness among investors than during previous retrenchments.

One major difference between the earlier years of the bull market in 2003 and 2004, and the more recent period since 2005, is a change in global monetary liquidity conditions – or the amount of money coursing through the economy, some of which makes its way into asset markets, pushing up prices (see box below).

Liquidity growth has slowed over the more recent stage of the bull market, potentially crimping future returns from a variety of assets. In contrast, liquidity levels rose in the earlier period at the fastest level for thirty years, according to some measures.

The slowdown in liquidity growth follows hikes in short-term benchmark interest rates during the past couple of years, from historically low levels, in a number of countries. In America, the Federal Reserve has raised interest rates 16 times since 2004, from 1% then to 5% now (see graph below). The European Central Bank, after leaving its benchmark rate unchanged at 2% for more than two years until 2005, has raised it to 2.5%.

Earlier this year the Bank of Japan ended its policy of “quantitative easing”, whereby it flooded its financial system with cash in a bid to revive its economy. In Britain, the Bank of England has raised rates from 3.5% in 2003 to 4.5% currently. Rates have been pushed up in emerging markets like China and India. Long-term interest rates – for example, the yield on the 10-year US Treasury Bond – have also risen over recent months.

Moreover, with inflation, and possibly inflation expectations, rising in a number of economies, partly because of a steep rise in energy and commodity costs since 2003, some investors think central banks will push rates higher still. For instance, the latest Merrill Lynch Fund Manager Survey, released in May, shows that a net balance of 32% of respondents believed global monetary policy was “too stimulative”, while a net balance of 71% expected higher central bank rates a year from now.

“During May’s stockmarket falls, it looks to me like tightening liquidity has suddenly started to have an impact on investors’ liquidity preference [or desire for cash],” says Andrew Smithers of advisers Smithers & Co. “They seem to have sharply increased their liquidity preference and this has had a short-term impact on markets.”

Smithers says that “recent evidence points to an increasing risk of inflation, probably because the world economy has grown a little more quickly than most people think”. This means that “expectations of interest rates have gone up a bit, and those expectations seem to have affected liquidity preference”.

“The worst thing that can happen to stockmarkets,” Smithers adds, “is a change in inflationary expectations, since modern central banking theory holds that if inflationary expectations pick up, central banks need to act vigorously and rapidly to prevent that continuing.”

“The global picture on interest rates has changed a lot,” says Mike Lenhoff, chief strategist at Brewin Dolphin Securities. “Rates in the US have gone up, though it looks as if the hikes there are coming to a temporary halt.

“The Bank of Japan is drawing back from quantitative easing and will probably pretty soon start raising rates. In the eurozone, the ECB has made it clear that it intends to continue pushing interest rates up. Global liquidity is being withdrawn and that will slow down the pace at which equity markets move ahead – though that isn’t to say they aren’t going to move ahead.”

“Our analysis suggests there is some slowdown in the rate of global liquidity growth,” says Andrew Milligan, head of global strategy at Standard Life Investments. “This understandably relates in part to what central banks have been doing and to the rise in bond yields and the cost of capital.

“Central banks, which in previous years injected a large amount of liquidity, have been waiting to take it away. We have seen the Bank of England normalise monetary policy, the Fed close to normalising policy and the ECB basically wanting to normalise policy in the months ahead.”

Milligan adds that “as liquidity is taken out of the system, we would traditionally expect to see some volatility in financial markets, particularly in the more speculative assets” and that he has “not been surprised” by the volatility this year.

Standard Life’s liquidity measure looks at the activity of 20 central banks and incorporates factors like the cost and availability of credit. Milligan says the measure is “optimised to relate to equity market performance” and he began to detect a slowdown in liquidity growth some time ago.

Other measures of global liquidity growth show a similar result. For example, one compiled by investment bank Merrill Lynch shows liquidity growing at about 2% at the start of 2001, rising to a peak of about 22% in 2004 and subsequently falling to around 12%, its current level. Merrill Lynch’s measure tracks changes in the sum of the American monetary base and the amount of American securities held by the Federal Reserve on behalf of foreign central banks.

Hong Kong-based financial consultancy GaveKal has a different measure of global liquidity, “M”, which suggests it is contracting. The sophisticated M indicator tracks the amount of money being pumped into the financial system by the three key central banks: the Federal Reserve, the European Central Bank and the Bank of Japan.

It is “built using the changes in monetary bases, the GaveKal monetary policy indicators, the marginal growth rate of M2 [an official measure of money supply], the US trade balance, reserves held at the Fed for foreign central banks, and absolute increases in both broad and narrow money supplies”, according to the consultancy.

During 2003 and much of 2004, GaveKal’s M indicator showed liquidity was expanding on a global scale. But since 2005 it shows liquidity has been contracting. In a recent review of global liquidity conditions, GaveKal’s Charles Gave writes that “central banks are in the process of withdrawing liquidity on a large scale”.

The end of quantitative easing in Japan, where the benchmark short-term interest rate is still zero, could be particularly significant, according to the consultancy. Its research suggests the Bank of Japan “created ex nihilo the equivalent of $400bn [213bn] of high-powered money” over 2002 and 2003, with the result that Japan’s monetary base is now bigger than America’s, even though Japan’s economy is half the size.

Over roughly the past ten years, GaveKal adds, “$1.8trn worth of Japanese capital appeared abroad”, thanks toa combination of quantitative easing, zero or near-zero rates and Japan’s exchange rate policy. This figure is equivalent to 15% of American gross domestic product, or 3% of the value of American assets. The explosion in Japan’s money supply also alludes to a “carry trade”, whereby investors are thought to have borrowed in yen to invest in higher yielding assets outside Japan.

All this cash has helped to drive a boom in global asset markets, according to GaveKal. But Japan has now abandoned its policy of quantitative easing, the yen has been rising and Japanese rates could go up later this year.

Japan’s monetary base is contracting for the first time since the year 2000 stockmarket bust, according to GaveKal’s research. “Contractions in Japan’s monetary base have not left us with fond memories,” the firm says. It is cautious about the outlook for equities.

“The Bank of Japan is now back-pedalling on a very lax monetary policy,” says Brewin Dolphin’s Lenhoff. “Money is not going to be so cheaply available in Japan for punters to race off to foreign markets to invest in higher-yielding assets. That is another reason why there will be less liquidity available…and possibly less momentum pushing markets ahead.”

However, even though global liquidity is growing more slowly than in the recent past, or contracting,

experts point out that a lot of money has nonetheless been pumped into the financial system in the past few years, and that the absolute level of liquidity is still high.

The “Marshallian K” measure of liquidity, for instance, suggests the US economy is more liquid than at any time in the past 100 years, except for during the Great Depression in the 1930s and World War II, according to research by Smithers (see graph below). Marshallian K can be thought of as a ratio between the supply of, and demand for, money. “Data for Europe, the UK and the US suggest monetary conditions are extremely loose,” Smithers says.

Smithers argues that many asset markets are in bubble territory and the outlook for equities is “doubtful”. But others feel that the fact liquidity conditions are still loose represents something of a cushion or support for asset prices, despite the recent volatility in financial markets.

“We are a long way from entering a period where global liquidity plunges sharply and becomes very tight,” says Standard Life’s Milligan. “For example, money supply growth in the Organisation for Economic Co-operation and Development was 10% per annum in the Spring. That is a very significant figure. Central banks are a long way away from taking aggressive action on rates too.”

Many equity markets are not “ridiculously or outlandishly” expensive, Milligan says. He argues that “so as long as the reduction in global liquidity growth remains moderate, and so long as the underlying backdrop of inflation, corporate earnings and valuations remains supportive, we are talking about a mid-cycle pause in the stockmarket”.

“A liquidity growth slowdown is clearly a shift markets have to come to terms with,” says Kathryn Langridge, head of international equity products at Invesco Perpetual. “But if you accept that inflation is broadly under control, and that interest rates are broadly responding to signs of growth in the world economy that aren’t excessive, then we don’t expect to see the punch bowl being taken away completely…We don’t see the start of a bear market.”

In a research note published late last year, Joachim Fels, a Morgan Stanley economist, said global excess liquidity – money in excess of the amount needed to finance transactions in the real economy – had been “on a steep upward trend since about 1995”. This had created an “unprecedented amount of liquidity…to chase bond, equity and other asset prices higher”, he added.

Much higher benchmark short-term interest rates, a big rise in consumer price inflation to double-digit levels or bank failures would cause that excess liquidity to contract, Fels said, but none of these outcomes looked particularly likely. More optimistic analysts would likely still broadly agree with this analysis.

Nonetheless, the fact that liquidity conditions are under the spotlight – and deteriorating, on some measures – is something of a break from recent history. Analysts are certainly watching carefully to see how changing liquidity levels will affect asset prices. Of course, economic and corporate profits growth, which some experts feel will slow in 2007, are under the scanner too.

Yet should stockmarket soothsayers bother with liquidity conditions at all? Many experts swear by the supposed relationship between monetary liquidity levels and liquidity growth, on the one hand, and equity markets, on the other. However, not all do.

In a speech in 2005, Roger W Ferguson Jr, then vice-chairman of the Federal Reserve, cast doubt on the link between liquidity and swings in real equity prices, and argued that “the effect of money growth on real equity prices is by no means a closed question” .

“Under various alternative specifications, the link between the growth rate of liquidity and changes in real equity prices at frequencies beyond the very short term appears to be tenuous at best,” he said, based on an analysis of academic research.

Indeed, a comprehensive survey of American stockmarket booms by academics Michael Bordo and David Wheelock concludes that “booms do not occur in the absence of increases in real economic growth and perhaps productivity growth. We find little indication that booms were caused by excessive growth of money or credit”.

As a result, investors might do well to rely on more than just liquidity trends as they bid to divine the prospects for equity markets.

Recent financial market stress

Strategists observed troubling developments in fringe equity bourses and the currency markets months ago, well before May’s more widespread global stockmarket falls.

These developments contrast markedly with previous periods, when nearly all assets appeared to be rising in value in unison.

The Icelandic stockmarket, for instance, began to wobble in early February. It has fallen some 16% since then. The Icelandic krona is down nearly 17.5% since the start of 2006, with so-called “hot money” – or short-term investors – rushing for the exit.

The fall in the krona has contributed to a rise in the inflation rate in Iceland to nearly 8%, while the country’s benchmark central bank interest rate is at 12.25% following a major hike this month.

Later in February, the Saudi Arabian stockmarket began a collapse, with weakness apparent elsewhere in the Middle East too. The Saudi Tadawul All Share index has nearly halved since a peak on February 23.

Elsewhere, risky stockmarkets succumbed to see-saw volatility, dropping and rising substantially during individual trading days.

Selling pressure has also been apparent in currencies – for example, the New Zealand dollar – which are thought to have been the target of “carry trades”, where investors borrow in a currency with a low interest rate and invest that cash in a higher-yielding currency.

The New Zealand dollar, on a trade-weighted basis, is down nearly 12% since the start of 2006. Inflation in New Zealand is now above target and its benchmark interest rate is 7.25%.

More recently, a tidal wave of selling has crashed across the world’s stock markets, with a mood of risk aversion apparently deepening.

The MSCI All Countries World index, after scaling a recent peak on May 9, subsequently fell a substantial 7.6% by May 24. In Britain, the FTSE 100 index was down a roughly similar amount over the same period.

Riskier markets fared much worse. India’s benchmark Sensitive index, for example, shed about 11% last week alone, and collapsed 10% in just two hours on May 22, forcing trading to be suspended.

For some analysts, such financial developments this year are indicative, at least in part, of either of an incipient liquidity squeeze or fears among investors that such a squeeze is on the way, which has caused them to shift out of riskier assets and into cash.

What is liquidity?

The term “liquidity” frequently crops up in discussions of the prospects for financial markets. But its ubiquitous use masks the fact that there are different ways of understanding and measuring liquidity.

The first major way to conceive of liquidity is as “market liquidity”, which “refers to the capacity of financial markets to absorb temporary fluctuations in demand and supply without undue dislocations in prices”, according to the International Monetary Fund.

Commentators use this idea of liquidity when they describe secondary markets as liquid or illiquid because trading has become easier or more difficult respectively.

The other key notion of liquidity is “monetary liquidity”. Broadly speaking, this refers to the amount of money swilling about in a national economy or the global economy. Monetary liquidity can be created in the public sector by central banks, or in the private sector by commercial banks.

Obviously market and monetary liquidity are related: assuming other things are equal, a big increase in money levels can provide funds for stockmarket transactions.

Many analysts and economists think the level of monetary liquidity, and its growth rate, are major determinants of various asset prices, such as equities, real estate and even art.

“Excess liquidity”, or money in the financial system over and above that needed to finance transactions in the real economy, is often cited as a particularly important indicator of financial market prospects, since it is money that can end up in asset markets. However, there is no single agreed measure of monetary liquidity or excess liquidity.

A number of experts focus primarily on the cost of money – short and long-term interest rates – to evaluate liquidity conditions. Others concentrate on levels of credit growth or official national money supply measures.

For some, it is essential to assess global liquidity conditions. This could be done, for instance, by adding the American monetary base to the amount of American government securities held at the Federal Reserve on behalf on foreign central banks.

To assess excess liquidity, some experts compare their preferred measure of liquidity growth with nominal economic growth. Liquidity growth above nominal economic growth is thought to signal excess liquidity.

Financial consultancies and global strategists draw on all this to single out their preferred measures of monetary and excess liquidity conditions.