The recent market sell-off tells me that the global liquidity contraction has begun, driven by a rising cost of capital, falling risk appetite and a reversal of carry trades. This will eventually cause a slowdown in world economic growth some time next year.
The huge blowout in high-risk debt will not be a one-way road to hell. Equity markets are due for a sigh of relief and could well rally back to their highs or higher before the next round of liquidity tightening takes them lower.
Most of my gainfully employed acquaintances working for big institutions on the sell side (who are 30 to 40 years younger than I am and a lot more intelligent and technically qualified to do the job) hold the view that there will be a rapid return of normal risk appetite in the autumn because the global economy is so powerful. So the party is paused like an in-flight movie, but not over – just a loo break.
I don’t believe this. The financial economy is now so big in relation to the real economy that it can be the locomotive of the train rather than a wagon. It is every bit as fundamental.
But there is another reason for my doubting the optimistic hiccup theory. It has to do with the New Monetarism theory of "reefs" rather than "bubbles". We all know there are bubbles around – US sub-prime being but one. But most bulls take refuge in the fact that core assets like equities and quality bonds have none of the characteristics of asset bubbles. I agree they don’t, but I draw scant solace from that observation.
When liquidity contracts, nearly all asset values fall, whether they are fairly or unfairly valued. It is the destruction in wealth that ultimately hits the economy, whether it is fundamentally justified or not. And I suspect we are at the beginning of a long, slow contraction of global liquidity.
New equilibrium
When liquidity drives up asset prices, this increases wealth and aggregate demand – and income and profits follow. This establishes a new higher equilibrium level of economic activity. But if both capital and labour productivity have not followed suit, this new higher level of wellbeing will be unsustainable and will fade when liquidity contracts and asset prices fall.
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Volatility and returns |
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CBOT’s Vix index and EMBI+ yield spread |
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Source: Datastream |
This holds even though the higher level of economic activity need not have resulted in higher inflation, due to most of the liquidity being designed for asset transactions and not for shopping (and externalities such as technology, internet and globalization, etc).
This liquidity-driven economy produces no bubble valuations as it shifts from low to (unsustainably) high gear. This is because all the variables (asset prices, profits, income, rents, etc) rise in tandem. The rising tide of liquidity lifts all boats equally. So valuations (ratios such as P/E, house price/rent, asset prices/income, etc) are all exactly the same at the new unsustainably high level as at the low level of the economy.
In other words, the "real" economy gives no signal that it will bust when financial assets do because there are no evident excesses.
In my view, that is where we stand now. The fundamentalists who believe that risk appetite will return to normal just as the apples start falling from the trees are ignoring the degree to which the current level of robustness in the global economy is dependent on unsustainable financial asset prices and the incredibly long period of liquidity expansion they have enjoyed.
There will be a Manichean struggle between those who believe that the global economy is sound and those, like me, who agree that it is, but believe it is nevertheless still vulnerable to a cyclical liquidity contraction. This speaks for many market rallies ahead.
But I believe they will not be turning points, but just codas in a declining symphony of returns. After this current blowout, equity markets might well rally back to their highs or higher. But eventually, the next round of liquidity tightening will take them lower.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com