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Good morning. Two months ago I wrote that a faint odour of fear was wafting through markets. Leverage in margin accounts had ticked down for the first time in over a year, fund managers were cutting equity exposure, defensive stocks were outperforming, high-yields spreads were widening a touch, and the cost to hedge equities was rising. The market, obligingly, proceeded to make me look smart for the entire month of September. Stocks fell by about 5 per cent.
Now I look dumb again. Stocks have taken all the losses back and then some, Tesla is worth a trillion dollars, bitcoin is at all-time highs, and fear is a memory. This market can take a punch. Thoughts on its resilience follow. Email me: firstname.lastname@example.org
Liquidity = flows = higher stock prices
There is a nice scene in the TV series The Wire in which the drug kingpin Stringer Bell, concerned about falling profits, tells his lieutenant D’Angelo Barksdale that their street-level dealers are going to take big pay cuts. D’Angelo says the dealers will stop working. Stringer’s reply (with a few words changed because this is a family newsletter):
What, you think they gonna get a job? You think it’s gonna be like, ‘Screw it, let me quit this game here and go to college?’ Nah. They gonna buck a little, but they ain’t gonna walk.
Stringer’s point applies to equity investors. Yes, economic and earnings growth are cooling, inflation looks sticky, and valuations are mad. But what, you think they gonna buy bonds? You think it’s gonna be like, ‘screw it, let me quit the equities game and go to cash?’ Nah. They gonna buck a bit, but they ain’t gonna sell.
Bonds yields look miserably unattractive here, as inflation expectations have pushed their real yields well below zero. That same inflation makes cash look even worse. Meanwhile, there is tons of money out there that investors have to put somewhere.
Here is a 20-year chart of weekly net flows into US stock funds (data from EPFR). It’s a wildly volatile series, so I have used a three-month rolling average to smooth it a bit:
This year has seen an unprecedented rush of money into US stocks funds, averaging at least $5bn-$10bn a week throughout. In the previous 20 years, nothing like this has happened, with the possible exception of the sustained positive flows in 2013, which were at a much lower level. In fact, from 2001 through to the end of 2020, US equity funds flows amounted to minus $126bn (the marginal buyer that supports the market has almost always been companies purchasing their own shares). This year alone, flows have totalled $306bn.
Here is the past 10 years of fund flows, plotted against the S&P 500, showing an imperfect but suggestive correlation:
How much of this has to do with those measly bond yields? Here’s a nice chart from Bank of America, showing household allocation to bonds from the national accounts; bond allocation from portfolios in Bank of America’s wealth management unit; and the net per cent of bond managers who say they are overweight bonds, from the banks’ fund manager survey. Bond allocations automatically fall when stocks rise, but no one seems to be selling stocks to rebalance back into bonds.
In the eyes of investors, bonds just are not a viable alternative.
While flows are the best proximate explanation for unstoppable US stocks, they cannot be the ultimate explanation. The money flowing into stock funds has to come from somewhere. And in fact it appears to be coming from everywhere, at least for now. CrossBorder Capital, in London, tracks global liquidity, which they define to include not just central bank balance sheets but liquidity creation from commercial banks, shadow banks, and other market providers. Here is their chart of increases in global liquidity by year, with estimates in red for this full year and next:
The deceleration is down to the behaviour of the three biggest liquidity providers — the eurozone, China and the US. China has been adding no net liquidity for months, despite the Evergrande crisis; Europe has already begun to slow central bank bond purchases; and the US is planning to do so soon.
CrossBorder takes the view that asset prices and changes in liquidity are closely linked. Here is their chart of that:
The message here is simple. It looks like liquidity will grow much more slowly in the months to come and next year. That will mean flows into equities will flag. And that will mean the rally might stall. You might argue — optimistically or cynically, depending on your point of view — that one or more of the central banks of either China, the eurozone or the US will blink, and turn the liquidity taps on again.
Many pundits expect the China “credit impulse” to go positive again before long. Could be. But Michael Howell of CrossBorder points out that in the case of Europe, the inflation Germany is experiencing might give a hawkish tilt to monetary policy in the months to come. Inflation may force the hand of the US Federal Reserve, as well.
Indeed, the obsession of investors with inflation is less about the damage spiralling prices can do to an economy than the fact that it could drive nominal and real bond yields higher, taking out one price support for risky assets, and could end liquidity-producing asset purchases abruptly, knocking out another.
It is no certainty that next year will be a rough one for stocks. If inflation cools, central banks may in fact rise to the rescue if there are signs of trouble. Another crucial variable will be corporate earnings. If corporate profits keep rolling in strong, that means more cash will be available to buy back shares, which will support stock prices even if flows into stock funds falter. I have argued that there is good reason to think that the strongest companies will continue to be extraordinarily profitable. Whether these companies can support the wider market is an open question.
One good read
A very interesting English-language editorial in Caixin Global, urging that China continue its push to end its dependence on real estate investment for growth, even in the face of a slowing economy. Hat tip to Michael Pettis for pointing it out. I am not sure how much Caixin reflects widely-held views in China, or coincides with the views of the Communist party. But if the expression of this idea in a prominent forum reflects a stiffening consensus against China’s old economic model, that’s a big deal.