Capital Markets Rumble: Liquidity vs. Fundamentals

Capital Markets Rumble: Liquidity vs. Fundamentals

March 07, 2023

There is a frenzied struggle currently in play within global markets, tilting against each other two titan macro factors: Global Liquidity and Economic Fundamentals.

At stake is the reaction function of investors to determine asset winners and losers for 2023.

In this corner, the challenger: Global Liquidity

   Three Sources:

  1. Government & Banking: central bank money printing & banking fractional reserve system
  2. Corporate: money from company revenues
  3. Cross-border: remittances

In the USA…

  • Since the Fed started draining liquidity over a year ago, through higher Fed Funds rates and Quantitative Tightening (QT = reducing the Fed’s balance sheet), overall liquidity had been declining. But from early October to mid-February, liquidity had stabilized through:
    • the Treasury’s use of their General Account (TGA),
    • the declining use of the Fed’s Reverse Repo facility and,
    • the curious stasis of the Fed Balance Sheet at $3 Tn. 
  • Reductions in the TGA loosen financial conditions because the balance is a liability on the Fed's balance sheet. When the Treasury spends from the TGA without new debt issuance, that money enters the economy through entitlement programs, such as social security and Medicare, government salaries and other spending. The funds are deposited at banks which can then be used as collateral for lending which is how new money is created. 
  • Ironically, a political showdown on the government’s debt ceiling could force the Treasury to draw down its remaining $355 billion TGA balance to avoid a technical default. That would be stimulative in the run-up as it would continue to offset the Fed’s efforts to drain liquidity through QT. 
  • Conversely, if the debt ceiling gets resolved tomorrow there would be no need to draw down the TGA which would, presumably, be a headwind for risk assets with less liquidity to offset QT.

Internationally…

  • China’s still fresh reopening from CV19 lockdowns has seen the PBoC inject over $450 Bn into Chinese financial markets in 2023 thus far. That’s ~3x what they injected in the prior two years. 
  • China set a growth target of “around 5%” for 2023, a goal of 3% for the consumer price index, and a 5.5% unemployment rate for people in cities with the creation of ~12 million new urban jobs.
  • The government report detailing these forecasts called for implementing “prudent monetary policy” in a “targeted” way.

 

In the opposite corner, the reigning champ: Economic Fundamentals

  • The rate of change in GDP, year over year (Y/Y), remains a key component to understanding where we are in cycle terms. To that end, one of our primary research partners, Hedgeye, forecasts two consecutive sluggish quarters to start 2023 in the United States.

Their 4-Quadrant Model, measuring rate of change in GDP & Inflation, remains a critical tool in our firm’s allocation process.  As you might assume from the red lettering associated with Quad 4 (decelerating GDP & Inflation dynamics), risk assets are forecast to remain under pressure for the intermediate term.

  

  • Nearly all the G20 economies are in a similar setup for the first two quarters, but Y/Y comparisons get easier in the back half.

Key excerpt from Hedgeye’s most recent 1Q2023 Macro Themes presentation:

“Inflation was last year's war and policy flows through real economic activity on a lag. Protracted (global & local) Quad 4, higher for longer rates, further negative acceleration in profit growth, and the largest liquidity contraction in a century will not be kind to markets and credits priced in that liquidity.”

  • Although we have some recent acceleration in China data of late, the March 7th reported Exports and Imports number remained negative:
    • China February Imports slowed to -10.2% Y/Y, versus -7.5% in January.  This has been negative since October 2022.
    • China February Exports accelerated for the first time since July 2022 to -6.8% Y/Y, but it’s still a negative Y/Y number.

One last note on Liquidity:

  • Consensus was generally expecting Fed Chair Powell to be hawkish in his March 7th testimony to the Senate. His prepared commentary was actually more hawkish than anticipated.  At 9:58am, prior to Powell speaking, the Fed Funds Futures had a 32% probability of a 50bps hike at the upcoming March FOMC meeting.  By 10:09am that had shifted to 50%.

Commentary from Powell included:

“The bank is prepared to increase the pace of rate hikes if the data indicates that faster tightening is warranted.”

“The process of getting inflation down to the 2% target will likely be bumpy, pointing to a broad reversal of the disinflationary trend in January.”

“The ultimate level of interest rates may be higher than expected.”

“Restoring price stability is likely to require maintaining a restrictive stance for some time, and added the historical record strongly cautions against prematurely loosening policy”

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JWA’s baseline thesis for Risk Assets (investment vehicles with long-term rates of return that exceed inflation but with periods of heightened volatility) revolves around a belief that there is significant technical “gravity” for the S&P 500 Index to revisit the pre-Covid high of February, 2020.  That level is 3394.  Markets tend to overshoot so we’re also eyeing the possibility of covering the late Feb-2020 gap down at ~3260 or lower.  Should we visit these levels we’d expect maximum fear to be propagating through the media and, if you remember your history, we want to invest “when there is blood in the streets, even if it’s our own.”

With our continued high allocation to low-volatility assets, along with some hedges to risk assets, we’re cautiously optimistic that any proverbial bloodletting will occur in the portfolios of others.

Sources:

Overnight Reverse Repurchase Agreements

Federal Reserve Statistical Release

Daily Treasury Statement

TC2000 

Hedgeye