morganstanley.com
Liquidity cycle has turned up. Importantly, in the most recent available quarter, G5 excess liquidity has started to rise again, for the first time in almost three years. In our view, this marks the beginning of a new global liquidity cycle.
Global
A New Global Liquidity Cycle
January 16, 2009
By Joachim Fels | London
In a nutshell. As GDP downgrades abound and investors’ gloom thickens, our metrics indicate that a new global liquidity cycle is in the making. While still in its infancy, this new liquidity cycle will likely help support asset markets, end the recession later this year and prevent lasting deflation. As always, it is difficult to predict which asset classes will benefit most from the build-up of excess liquidity. However, our strategists favour credit and EM equities in 2009.
Focus on global excess liquidity... Our favourite metric for tracking the liquidity cycle remains the evolution of excess liquidity, which we define as the ratio of money supply M1 to nominal GDP (a.k.a. the ‘Marshallian K’). M1 is a narrow monetary aggregate comprising currency in circulation and overnight bank deposits held by non-banks. It is used for transactions in the real economy – when buying goods and services – and in the financial sphere – buying stocks, bonds or other financial assets. Simply speaking, if money grows by more (less) than nominal GDP, excess liquidity expands (contracts), and more (less) money is available for transactions in the financial sphere. We plot our measure of excess liquidity both for the G5 advanced economies and for the four BRICs as a proxy for the emerging world. With money highly mobile across borders, we prefer such ‘global’ measures of excess liquidity to national ones.
…as a driver of asset prices. As we have argued repeatedly over the years, the ups and downs in excess liquidity have been key drivers of past asset price booms and busts. The bond market rally of the early 1990s was led by a build-up of excess liquidity and gave way to a bond bear market in 1994 as excess liquidity evaporated. A renewed build-up of excess liquidity was also behind the equity bull market in the second half of the 1990s. It culminated in the dot.com bubble, which burst early this decade as excess liquidity turned down. And the mother of all credit and real estate bubbles up until 2006 was fuelled by the surge in excess liquidity that started in 2002 and lasted until early 2006, just as the downturn in excess liquidity from 2006 onwards foreshadowed the bursting of these bubbles in 2007/08. It is interesting to note that while G5 excess liquidity contracted already in 2006, the surge in excess liquidity in the BRICs at that time probably prolonged the surge in asset prices (mainly equities and commodities) into 2007. Only when BRIC excess liquidity also evaporated during the 2007 monetary tightening campaign did asset markets tank collectively.
Liquidity cycle has turned up. Importantly, in the most recent available quarter, G5 excess liquidity has started to rise again, for the first time in almost three years. In our view, this marks the beginning of a new global liquidity cycle. We illustrate this more clearly by showing the quarterly growth rate of excess liquidity (rather than the level).
Excess liquidity is surging because M1 growth has started to rise at a time when (nominal) GDP growth is decelerating sharply. As we see it, excess liquidity is likely to accumulate further in the next few months and quarters, for several reasons:
• With interest rates already close to zero in several countries and being cut further in others, the opportunity costs of holding cash and non-interest bearing deposits (M1) have declined.
• By flooding banks with excess reserves (‘quantitative easing’), central banks have provided banks with plenty of wherewithal to create new deposits by lending to non-banks or buying securities.
• By targeting mortgage rates and other private sector lending rates directly through purchasing asset-backed securities (the Fed now prefers to call this ‘credit easing’ rather than ‘quantitative easing’ as per Chairman Bernanke’s speech last night), the Fed is supporting credit demand, which in turn supports deposit growth.
• With real GDP shrinking across the industrialised world and consumer prices heading south, nominal GDP – the denominator in our definition of excess liquidity – will likely decline in the near term.
Thus, 2009 is likely to mark the beginning of a new liquidity cycle, driven by the unprecedented conventional and unconventional easing of monetary policy as well as a gradual healing of the impaired financial system.
Surging excess liquidity is likely to have three consequences:
• As in past episodes, excess liquidity will find its way into asset markets. To some extent, this has already started to happen, with government bond yields having been pushed to new lows across the yield curve, credit spreads coming in and equities having bounced off their lows from last autumn. Our excess liquidity metrics tell us nothing about which asset classes will benefit earlier and most. But our strategists favour credit over equities and government bonds, and EM equities over developed market equities.
• By pushing interest rates lower and asset prices higher, excess liquidity should help to end the recession later this year. Despite their recent renewed growth downgrades, our economists in the various regions continue to envisage a recovery (though a muted one) during 2H09.
• Rising excess liquidity should also help to prevent a sustained period of consumer price deflation through its impact on asset prices, the real economy and inflation expectations.
Bottom line: Despite the massive growth downgrades, investors shouldn’t get too gloomy on markets in 2009, now that excess liquidity – a powerful driver of asset markets in the past – has started to turn up. It’s time to get ready for the new global liquidity cycle. |
