‘It Took Unprecedented Liquidity Merely To Stabilize Risk’

“It’s all about liquidity.”

That’s a popular refrain when it comes to explaining how risk assets have managed to perform in a year that witnessed the single worst economic downturn since the Great Depression.

It’s funny, too: A veritable who’s who of the financial pantheon, all of whom would have been more than happy to regale you with some version of a “don’t fight the Fed/rising tide, all boats” narrative pre-pandemic, abandoned that old saw in March and April. You can’t really blame them. It was a terrifying moment in history.

But, as the visual (above) makes clear, doubting the gods’ capacity to levitate financial assets with trillions in liquidity meant missing out on what, by some measures, was the most spectacular rally in recorded history. Lesson learned — again.

And yet, there’s some nuance to be had. And the nuance is important.

“When a system is in crisis, it begins to break its own rules,” Deutsche Bank’s Aleksandar Kocic wrote, in his year-ahead outlook dated December 8. “Liquidity used to be one of the key drivers of the markets, the tide that lifts all boats,” he went on to say. “Clearly, not anymore.”

The figure (below) shows excess liquidity with the 6-month MA of returns on annual changes of the price/diluted earnings ratio.

“While in the past the two series tracked each other closely, that relationship has either fallen apart or is undergoing a structural shift,” Kocic remarked.

One is reminded of myriad visuals illustrating diminishing returns (in terms of growth) from taking on more debt. Only, the decoupling shown above is as sudden as it is dramatic.

“It appears that it took an unprecedented increase in liquidity in 2020 merely to stabilize risk,” Kocic said, in the same note, adding that “the apparent ‘overshoot’ was necessary to help the banking system and ease government borrowing costs and catalyze more extensive fiscal injection.”

In other words, it’s a manifestation of the coordinated maneuvers necessary to cope with what Kocic described as a “multidimensional problem of convexity management.”

The solution to the crisis isn’t found in policy, though. The path back to normality is forged by science. And the underlying socioeconomic issues laid bare in 2020 can only be addressed through transformative change.

“Monetary and fiscal stimuli are just temporary palliative remedies,” Kocic said. “‘Painkillers’ intended to make the transition period easier.”

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