Barron's:Liquidity and The Markets: This Time it is different.
Liquidity and Markets:
This Time It's Different
November 6, 2000
Other Voices
By JOSEPH CARSON
Today, as in the autumn of 1998, equity prices are sinking, corporate
bond spreads are widening fast, Treasury yields are falling, and the dollar is
super-strong. Yet what is lost in this comparison is that the economic backdrops
of the two periods are fundamentally different, and so, too, should be the
outcomes.
Perhaps the most striking difference between the two periods lies in the pace
and direction of liquidity flows. Liquidity, as gauged by the money and
financial-flows index, is much lower now, and still is decelerating.
Created by the Department of Commerce almost 30 years ago but
redesigned and maintained by me for more than a decade, the liquidity index
measures the change in demand for money and credit based on trends in real
M2 (a measure of the money supply), the change in business and consumer
credit and the growth in shorthand long-term liquid assets.
The grouping of several financial indicators into a composite index was done to
increase the chances of getting unambiguous signals and to reduce or even
eliminate false signals.
During the past 40 years -- a period that spans five business cycles of
varying duration, speed and composition -- the liquidity index has established a
near flawless track record of telegraphing turns in the economic growth cycle
well in advance
Its strong track record over the past several years underscores its unique
forecasting ability.
Even as the consensus repeatedly argued that the economy would slow in
the year ahead, if not immediately, the continued fast gains in liquidity flows
signaled that the economy would power ahead, registering gains in real gross
domestic product of at least 4%. And true to form, the economy posted real
GDP gains of 4% or more in 1997, 1998 and 1999, and it is almost certain to
repeat that again this year.
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Even in the autumn of 1998, when the financial markets greatly raised the
probability of an economic downturn in early 1999, the liquidity index signaled
that the risk of recession was greatly overblown. Why? Because liquidity flows
were exceptionally strong, and the U.S. economy never had suffered a hard
landing when liquidity flows had been so robust.
Moreover, I argued at the time, if the Federal Reserve felt compelled to lower
official rates in response to financial market dislocations, the correct investment
decision would be to buy stocks and sell bonds. The proposition was clearly a
risky one at the time and one that ran counter to consensus thinking. Yet based
on my liquidity framework, it was the right strategy call at the time. After
all, liquidity flows are highly sensitive to changes in interest rates and any sizable
Fed easing would only quicken liquidity flows that already were running fast.
Plainly, the economic and financial results of 1999 followed the script as
forecast by liquidity trends. Real GDP grew 5%, well above consensus
estimates, while corporate earnings jumped more than 17%, and the S&P 500
posted a 19.5% gain in 1999. Lucky call, some may say. Perhaps, but much
more important, I think, were the 40 years of history that linked changes in
liquidity flows to economic cycles, operating earnings and stock-market
performance.
Today the trend in liquidity flows is decidedly weaker than in 1998. Indeed,
in September the year-to-year gain was estimated to be 2.5%, the weakest gain
in five years. Even more troubling is that liquidity flows have been stagnant since
the beginning of the year -- the weakest nine-month stretch since 1994.
Moreover, if current trends extend through yearend, the liquidity index would
show no growth over a 12-month span for the first time since 1991.
Part of the protracted weakness in liquidity flows is the result of the ongoing
rise in energy prices. While many analysts argue that the U.S. economy
is less sensitive to oil prices than it was in years past, energy prices are still
important. The economic effects of a rise in energy prices include not only
the traditional loss of real income, but also new income effects, which arise from
reduced company earnings, the associated fall in stock prices and the attendant
decline in the value of stock options. By our calculation, the market value of
stock options on the books of S&P 500 companies declined by more than
$125 billion by the end of the second quarter.
Higher energy prices both drain liquidity and limit the flexibility of
policymakers by raising inflation risks. Also, it is not mere coincidence that sharp
decelerations (if not declines) in liquidity flows have occurred during periods
marked by rises in energy prices and official interest rates. That combination
almost always has proved to be deadly for the economy and the financial
markets.
Rising energy prices are problematic because policy makers must guard
against a spillover of those prices to other prices that would lift household and
business inflation expectations.
In 1998, inflation was not a concern. In fact, if there was a concern it was more
on the deflation side because commodity prices were tumbling in an already
low-inflation environment.
Today the concerns of policy makers are fundamentally different. They are
worried that ongoing increases in energy prices could lead to an environment
where rising price expectations start to become a bigger factor in household
spending decisions.
The upshot of all of this is that the economic fundamentals -- and thus the
concerns of policy makers -- in the autumn of 2000 are dramatically different
from those of 1998. Indeed, liquidity flows are slowing quickly and energy
prices are rising fast, the reverse of 1998. As a result, policy makers are unable
to lower rates to cushion the economy and the financial markets as they did in
1998.
For these reasons it is easy to see that the coming year will not repeat the happy
outcome of 1999.
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JOSEPH CARSON is chief economist for the Americas at UBS Warburg.
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