U.S. Liquidity Picture Needs Improvement
(September 15, 2011)
Dear Subscribers and Readers,
The reassurances of financial support for Greece from Germany and France notwithstanding, the European Sovereign Debt Crisis rages on. All countries within the Euro Zone would need to make more sacrifices. European banks, in particular, would need to raise more capital or obtain government support; on the bright side, U.S. banks remain relatively healthy, as long as housing prices stabilize (it would help if the Feds stop dumping its housing inventory into a declining market). The potential for more “Black Swan” events remains very high. However, should the Dow Industrials decline below 11,000 again, we will seriously think about initiating a 50% long position in our DJIA Timing System. Note that there is significant support in the 10,000 to 10,500 range should the market embark on another correction.
With the resignation of Jurgen Stark, the European Central Bank has lost a significant amount of credibility for its original price stability mandate. Coming on the heels of ECB purchases of Spanish and Italian sovereign debt—along with the shocking Swiss intervention in the currency market to cap the value of the Swiss Franc—nearly all of the world's major central banks have deviated from their mandates of price stability and price discovery. Going forward, we believe there's little the world's central banks can or should do to “prop up” the global economy, as some of the economic headwinds are structural in nature (lack of investment spending, significant entitlements, lack of innovation, etc.). Somewhat worryingly, the picture for U.S. and global financial liquidity remains mixed.
Let's first look at global liquidity, as measured by the amount of US$ available in the world. This is important as most global trade is still transacted in U.S. dollars. In other words, despite the advent of the Euro and the Chinese Renminbi, the U.S. dollar remains the “lubricant” for world trade. Similar to a game of musical chairs, the “marginal” U.S. dollar borrower (e.g. Thailand in July 1997, Brazil in 1998, and Argentina in 2002) will be cut off if there is a declining supply (or a decreasing growth in supply) of U.S. dollars—resulting in a liquidity squeeze in major parts of the world. In such a scenario, the U.S. dollar and U.S. assets (e.g. Treasuries) would outperform. One indicator/measure of a potential US$ liquidity squeeze is the growth in the amount of foreign central bank reserves (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve. Whenever the rate of growth of foreign assets held at the Federal Reserve banks decreased substantially, the U.S. Dollar has almost always rallied—typically resulting in some kind of foreign/global financial crisis. This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value. The following chart showing the level of foreign reserves vs. the annual change in foreign reserves (from January 1982 to August 2011):
Ever since the demise of the Breton Woods Agreement in 1973, the world has been on a de-facto U.S. dollar standard. Therefore, as world trade expanded, the demand for dollar has increased—and with it, the increase of foreign dollar reserves held at the Federal Reserve Banks. It is interesting to note that various financial crises or economic recessions (see above chart) have usually occurred when the annual change of dollar reserves is slowing down or experiencing negative growth. This growth rate has been as high as 36% in August 2004 but it has been decreasing since the beginning of 2010. The annual growth rate for August 2011 declined to just 9.1%--its lowest growth rate since October 2002! As US$ liquidity growth declines, other crises will inevitably pop up—and as such, the European sovereign debt crisis is likely to get worse.
Let's now specifically look at U.S. financial liquidity. U.S. financial liquidity remains mixed, and is thus insufficient to prevent another market correction. From a domestic standpoint, both the Fed and U.S. commercial banks need to play a big role to revive bank lending and economic growth. Over the intermediate to long run, bank lending needs to revive for a sustained uptrend in asset prices and economic growth. Following is a monthly chart showing the state of U.S. bank lending—i.e. the year-over-year change in loans and leases by held by U.S. commercial banks for the period January 1950 to August 2011:
While the decline in bank lending in 2009 was unprecedented (the Great Depression notwithstanding, when one-third of all US banks failed), it has steadied in the last 15 months. Bank lending growth, while still negative on a year-over-year basis, is only down 0.3% (compared to -1.0% in July). In fact, the absolute amount of bank loans and leases outstanding (seasonally adjusted) rose by $40.4 billion (to $6.81 trillion) from the end of December 2010 to the end of August 2011. However, this recent liquidity creation within the U.S. commercial banking system would not much improve the stock market's short-term outlook.
Meanwhile, U.S. stock market liquidity has steadily improved since April but remains mixed. One measure of this is the amount of cash sitting on the sidelines, as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background. Since its February 2009 peak, it has declined very quickly, but has bounced in the last five months. As of the close last Friday, it is just under five percentage points above its cyclical bull market low (set at the end of April 2011), as shown in the following chart:
As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has consistently declined since February 2009. The ratio bottomed at 28.06% at the end of April 2011, and has bounced to 32.80%. This liquidity reading remains low, however, and along with the possibility of more “Black Swan” risks, this suggests market conditions should remain tough going into early Fall.
Henry To, CFA, CAIA