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Some Random Thoughts on Liquidity and Deleveraging

(March 5, 2009)

Dear Subscribers and Readers,

All eyes are now on the Bank of England.  With its current policy rate of 1.0%, both analysts and investors alike are now expecting a further cut to “near zero” territory, with most of them expecting a cut in the 25 to 50 basis point area.  By the time you read this commentary, the Bank of England may have announced its policy decision already.  More importantly, the Bank of England is expected to shift to a “quantitative easing” policy, with the Bank directly creating money by purchasing up to 100 billion pounds in government and commercial securities from banks.  Without further easing or similar plans from the rest of the world (mostly notably the US and China), my sense is that this will offer limited help for both the UK and global economy, but this is a step in the right direction.  Again, how this will play out in the next couple of months will depend on other government's policies, as well as whether the Pound could retain its value (or allow for a controlled devaluation).

Of course – at the margin – the creation of more Pounds by the Bank of England will be bullish for global liquidity.  Note the “quantitative easing” policy adopted by the Bank of Japan in 2001 was ultimately bullish for both the Japanese economy and the global economy – the latter especially after Japanese retail investors started exporting capital to other countries (now known as the “yen carry trade”).  While the yen carry trade certainly carried with it major currency distortions (given the dichotomy of Japanese interest rates with those of the rest of the developed world), the current QE policy adopted by the Bank of England will presumably bring with it less currency distortions, since interest rates are now very low across the developed world.  The urge to create more liquidity has not been lost on Japan, as the Bank of Japan has also started ramping up its monetary base, as indicated in the following monthly chart showing the year-over-year growth (and its second derivative) in the Japanese monetary base vs. the Nikkei:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly)(January 1991 to February 2009) - While the y-o-y growth in the monetary base (6.4%) is now at its highest level since May 2004, the BOJ still has its work cut out for them, as the monetary base is still at near its below its April 2006 level. More needs to be done!

As shown on the above chart, the year-over-year growth in the Japanese monetary base just hit its highest level in nearly five years!  That said, the year-over-year growth rate of 6.4% is still relatively low compared to those during 2001 to 2002 – suggesting that the Bank of Japan would need to do more (such as buying corporate bonds or securities directly from banks or from the secondary market) to unfreeze the local lending market and to reliquify both the Japanese and the global economy.  For now at least, the Bank of Japan is moving in the right direction.

Over in Germany, the government has finally announced the terms of its US$145 billion bailout fund for the country's corporations, including subsidiaries of foreign companies (such as GM's Opel).  Combined with two previously announced “fiscal stimulus” packages, total German aid to the private sector (not including banks) so far is approximately US$230 billion.  Over in central bank land, the European Central Bank is also expected to cut rates further – although any rate cut at this point will have little effect unless it is accompanied by more unconventional monetary or fiscal policies.  Surely, the European Central Bank should now recognize the region's dire straits.

With regards to the deleveraging of both the financial sector and the global economy (which has been a constant topic for us in the last 12 months), it was definitely encouraging to see the Fed finally stepping in to provide loans to the private sector in terms of the US$1 trillion TALF, which is expected to begin operations later this month.  Many private equity firms such as Blackstone, Cerberus, and Fortress have indicated interest in participating in the program.  Interestingly, none of these buyout firms has much prior experience in investing in debt (distressed or otherwise).  So why are these firms focusing on AAA-rated debt, and not their bread-and-butter (buyouts), you may ask?  Simple – the leveraged loan market, despite the decent valuations in the equity markets, is still effectively closed.  Moreover, with junk bond yields still in the stratosphere, it still does not make sense to engage in leveraged buyouts in any company or under any capital structure.  Despite nearly $1 trillion of private equity capital sitting on the sidelines, there is still no rush to getting back into the buyout market.  While the TALF is a good start, corporate bond rates in general will need to decline until we get a sustainable revitalization.

As discussed before, the deleveraging is also evident in the stock market – with many investors cutting back on buying stocks on margin over the last 18 months, as indicated in the following monthly chart showing the Wilshire 5000 vs. total margin debt outstanding from January 1997 to January 2009:

Wilshire 5000 Vs. Margin Debt Outstanding(January 1997 to January 2009) - 1) * Ratio = Margin debt divided by Wilshire 5000 divided by 10 2) Total margin debt decreased $10.7 billion during January to $199.4 billion, from $210.2 billion at the end of December 2008. Margin debt outstanding has decreased by a whooping $143.9 billion in the six months ending January This immense rate of margin debt liquidation is unprecedented. Even during the 2000 to 2002 bear market, margin debt outstanding never declined so quickly. From its peak in July 2007, the amount of margin debt outstanding has now declined by 52%, and is now at its lowest level since October 2004.

Total margin debt outstanding has now declined by 52% (or from $416.4 billion to $199.4 billion) from its peak in July 2007 to January 2009. During the March 2000 to September 2002 deleveraging phase (the stock market bottomed on October 9, 2002), total margin debt outstanding declined by 55%.  That deleveraging phase, however, took a “whooping” 30 months.  There is no modern precedent for this.  For example, even during the bear markets in the late 1960s and early 1970s, margin outstanding never declined so quickly.  From its peak in June 1968 to the bottom in July 1970, margin debt outstanding declined by 44%.  That deleveraging took 25 months.  Similarly, from its peak in December 1972 to November 1974, margin debt declined by 51%.  Subscribers who invested during the 1973 to 1974 bear market may have remembered it as one of the most ferocious bear markets ever – as pension funds, insurance companies, mutual funds, and retail investors all liquidated into a hugely unforgiving market – but even then, it still took 23 months for margin debt to decline by 51%.  Since the market experienced another round of liquidation during February, there is no doubt that total margin debt outstanding declined yet again during February.  From its peak in July 2007, my sense is that total margin debt outstanding has declined by more than 55% from the peak, exceeding its total percentage decline during the March 2000 to September 2002 bear market.

It would be interesting to observe the market's reaction to the Bank of England's QE policy and the latest European Central Bank rate cut.  Of course, the actual, tangible effects may simply come from the more gradual policies that were implemented in the last few months – such as TALF, Obama's various housing policies, the latest spike in the Japanese monetary base, and China's renewed commitment to strive for an 8% GDP growth this year (with a signal to yet again increase its fiscal stimulus spending if it needs to).  For now, it continues to look like that, for the most part, global policy makers are still doing everything they can to arrest a further decline in the global economy.  In the meantime, the fact that China has exhibited relative strength is highly encouraging, as the US will definitely need the Chinese economy to raise its domestic consumption and imports in order to embark on a sustainable recovery.  With Chinese consumer price inflation now cooling down to just 1%, I expect the People's Bank of China to cut rates again sometime in the next few weeks.  I will put together more thoughts this weekend.

Signing off,

Henry To, CFA

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