In my experience, there is nothing so powerful for asset markets as an “unquantifiable positive story and a tonne of liquidity”. Russell Napier’s Library of Mistakes in Edinburgh looks brilliantly at some of the madness that has taken hold of financial markets over the centuries (well worth a visit if you are ever nearby), and of course Edward Chancellor’s Devil take the Hindmost is the seminal text on the subject of credit-financed investment madness, but I have seen my fair share of mad booms firsthand.
My first real job in the industry was during 1987, when there was talk of a renaissance in the UK’s supply side (which of course you can’t measure..). Certainly, there had been a renaissance of some kind, but one could not quantify it at that stage. Nevertheless, this became the excuse for a powerful “run” in UK equities, although I suspect that it was of no coincidence that money and credit growth was running at a record-breaking the mid-twenty percent per annum range at the time.
From the UK, I moved on to cover Japan in 1989 – yet another credit boom was occurring and asset prices were inflating wildly. This time, the proffered excuse for rising asset prices was Japan’s difficult to measure “shortage of land” and people had even started valuing railway companies on the basis of the land between the tracks! Today, land prices have collapsed along with the credit system, but the country’s topography remains unchanged.
From Tokyo I moved to Hong Kong and witnessed a tidal wave of liquidity sweep through the dollar-linked Region as the Federal Reserve experimented for the first time with what would ultimately become known as QE. Asset prices surged on the back of abundant liquidity, while the marketing guys talked about economic supremacy and China’s rise over the coming decades. Words like “potential” were used with abandon, even as current corporate profits imploded. The credit was temporarily withdrawn in 1994 and markets fell by a third. In 1997, they collapsed as the Fed threatened to tighten.
By chance, my next assignment was to California. I watched first hand as the Tech Bubble unfolded – our bank’s own CIO claiming that valuations meant nothing in the new world. Unfashionably, I visited the Fed in Washington and compiled flow of funds data to show the true extent of the credit boom that was occurring. Invited to a conference in Cambridge at the straw-man-bear in late 1999, I heard corporate finance guys urging companies to hire more cleaners simply because their rule-of-thumb was to bring tech companies to the market at $1 million per employee (I kid you not…). The boom of course ended spectacularly when the Fed raised rates and also took action to limit the amount of credit being used by the corporate finance guys. Then the frauds appeared – and the lawsuits against analysts.
Then it was back to Europe and years spent covering the great mortgage boom that took us to the GFC. I like the film “The Big Short”, not least of all because so much of it is true-to-life. However, even the events of 2004-7 don’t seem quite as mad as 2020-2021, when a global pandemic destroyed several percentage points of the world’s productive capacity, but markets rallied on the back of abundant – and inflationary – liquidity. Finally, I seem to have moved to a small island, just in time to witness its economy struggle under the weight of a hugely overvalued real exchange rate (the result of a decade long credit boom) that no one wants to talk about.
What have a learnt in this 36 year-narrative (other than the fact that me moving somewhere is usually the kiss-of-death for the local economy)? The first lesson is that a preferably “hard to quantify positive story” plus liquidity will give you an intense asset price boom, not least of all because if you can’t quantify the story it is hard to analyse it. Secondly, I have learnt that no one really wants these booms to end (particularly policymakers). They always go on for longer than I expect. Thirdly, the booms usually only do end when they have to, and the thing that usually makes them have to end is inflation. This brings us on to the situation today.
In recent days, both the Federal Reserve and the Bank of Japan have seemingly pivoted towards more dovish than expected policy regimes. In Japan, the narrative is that the economy is not strong enough and inflation not high enough, while in the US the narrative is centred on a weaker economy and slower inflation.
Our work on Japan suggests that inflation is becoming entrenched, while we note that the US economic data is not in fact particularly weak. US GDP growth has averaged more than 3.5% in 2023H2 - well above trend – despite a destocking cycle within the manufacturing sector, and even the talk of a capitulation by the consumer seems overdone given the continuing strength in the retail data. Average wage inflation is lower but not because wage inflation rates are slowing in the individual industries, but because jobs growth is disproportionately occurring in lower income professions, and this is dragging the (weighted) average data down.
USA: Retail Sales
Nominal % 3 mth 3mma saar
There is then a narrative about economic weakness, but the data is at best equivocal or simply contradictory. Moreover, the most recent data from Asia – long the canary in the global coalmine – has started to look significantly stronger. There is a narrative that the world is slowing and that inflation is “over” but the actual data paints a different picture. The response to these observations is that “the recession is coming…”
What we do know, however, is that since around the 1st November, the US Treasury, and to a lesser extent the Federal Reserve, have presided over a massive expansion of USD liquidity. The US authorities are pouring liquidity into the financial system, and the banks are recycling this into a veritable explosion in lending to Hedge Funds and others. No wonder the financial markets are booming and the USD has been weak as liquidity has spilled out of the US into other markets. In Australia, the RBA has attempted to lean against this tide but has seemingly suffered a Canute-like defeat as the tide of liquidity has swept into the economy.
USA: Bank Credit to Public Sector (Net)
% 5 weeks sadj
As recently as late September 2023, the Fed was overtly hawkish but by early November it was easing. Three weeks ago, the BoJ was set to tighten but this week it did nothing and instead is continuing with its QE, albeit in the guise of Yield Curve Control. We think that these U-turns have occurred because, once again the central banks are being called upon to provide suitably accommodative conditions so that election-facing / scandal hit governments can fund their yawning budget deficits without suffering instability in their bond markets.
In short, Biden et al are scared of suffering a “Truss Moment” in their own debt markets. As such, the central banks are repeating the mistakes that they made in 2020-21 – printing money through whatever means they find convenient in order to suppress bond yields and thereby prevent governments facing binding financial constraints.
Of course, the central banks’ actions during 2020-21 led to the inflation of 2022 and it is our fear that the banks’ actions of 2023 will have a similar impact in 2024. Inflation expectations, Asia’s export prices, and property prices globally have started to rise again, the CPI’s may follow in the second half of 2024 and presumably this will force yet another U-turn from central bankers.
USA: Inflation Expectations
ISM Indices, NFIB, Consumer Sentiment
In the near term, the narrative (if not the fact) of a slowing economy and rising liquidity should sustain asset prices (albeit at the expense of a weaker USD) but, by mid-2024, we expect fears of inflation to return to haunt markets. Having just had “a rally for the ages”, fixed income markets could start to look vulnerable in the latter part of the first quarter and we suspect that other marketss may get more nervous as the year continues.
Liquidity booms can provide – and have recently provided – great returns in asset markets but one has to be careful not only not to sell too soon (a common failing of mine), but also not to linger too long. We shall be watching the data and trying to gauge when either the narrative will change, or when the liquidity will simply run out.
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