The relative importance of liquidity versus fundamentals as determinants of risk assets is everywhere and always a “me or your lyin’ eyes” kind of dynamic.
It’s difficult to establish mathematically, but certainly not conceptually. Harley Bassman captured it well: “Clever quants will say a statistically significant mathematical correlation doesn’t exist between money creation and financial asset prices, but who are you going to believe?” The implication is clear enough.
The problem isn’t so much in determining whether abundant liquidity plays a role in levitating financial assets, compressing spreads and suppressing volatility. It plainly does. The question is whether it’s possible to use liquidity proxies as near-term predictors of, for example, equity prices.
If you ask Deutsche Bank’s Parag Thatte, the evidence is inconclusive at best. “Post GFC, amidst unconventional monetary policy and a series of QE programs, the narrative took hold that the equity rally was driven entirely by Fed ‘liquidity,’ and it has gained even more influence in the last three years,” Thatte wrote, in a new note co-authored by Steven Zeng.
There’s no one measure of “liquidity,” but Deutsche Bank used the Fed’s balance sheet adjusted for reverse repo and the TGA to capture the latest version of the liquidity narrative which, as regular readers are no doubt apprised, posits a swoon for equities in part due to liquidity drain from a deluge of T-bills.
Deutsche Bank is in the camp that believes a “substantial” portion of new bill issuance will be absorbed by money market funds exiting RRP, but that’s almost beside the point for Thatte, who expressed a lot of “skepticism” about the idea that what happens to stocks from here will be a function of liquidity.
“Most of the gains in equities since the GFC and over the last three years are easily explained by fundamentals, leaving very little for the role of liquidity,” he wrote, adding that,
The appeal of the liquidity narrative stems from the notion that equity returns since the GFC cannot be explained by fundamentals and therefore have necessarily been driven by Fed liquidity. To the contrary, the equity rally since the GFC can be easily explained by fundamentals such as earnings and macro growth. Indeed, almost all the gains in the S&P 500 since the GFC are tied 1:1 with a rise in earnings. Only a small portion of the gains have been driven by changes in the equity multiple, which are in turn also easily explained by fundamental drivers such as payout ratios and inflation, with a tiny role then left for liquidity, if any. Likewise, all the gains in the S&P 500 since the beginning of 2020 are also tied 1:1 with earnings.
Needless to say, not everyone would agree with that assessment, notwithstanding Thatte’s efforts to back it up with math.
The figure below is straightforward: The relationship between liquidity and equity returns isn’t as consistent as the relationship between ISM and stock performance, or at least not when measured on a six-month basis.
Bassman would doubtlessly contend that this is yet another example of “clever quants saying a statistically significant mathematical correlation doesn’t exist between money creation and financial asset prices.” He’d also surely reiterate that this is a debate where efforts to quantify the relationship should be secondary to subjective assessments.
Somewhat ironically, appeals to “common sense” in this debate echo Ben Bernanke’s 2010 Op-Ed in The Washington Post. “Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action,” Bernanke said, of QE 2. “Easier financial conditions will promote economic growth. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion,” he went on.
Note from Bernanke’s assessment that this is a chicken-egg dilemma by design, which is why it’s hard to assess whether liquidity or fundamentals are ultimately in the driver’s seat. One thing we know is that the better off you were in terms of financial asset ownership, the better you generally did during the long period of excessive liquidity provision. I don’t think it’s disputable that the Fed overestimated the efficiency of the transmission channel from monetary policy to the real economy, and underestimated the efficiency of monetary policy largesse for boosting asset prices.
I should also mention that the math itself is malleable to the extent you can make the numbers say anything you want depending on measurement windows, what you use to proxy for fundamentals and so on. BofA’s Savita Subramanian, for example, calculates that over the past decade, half of the change in the S&P’s multiple was attributable to QE. Subramanian has also illustrated the diminished role of fundamentals in explaining stock returns in the post-GFC era. For example, from 1997 to 2009, earnings explained 48% of market returns versus just 23% from 2010 to 2021. She used the r-squared of S&P forward earnings versus monthly index returns to come up with those figures.
For Thatte, though, the inconsistency of the relationship between Fed liquidity and equity returns suggests the narrative is “in fact largely spurious.” By contrast, he wrote, “the correlation between equities and macro growth is strong, consistent, long standing, and intuitive.”
In addition, Thatte noted that stock returns are “also well explained” by reference to supply and demand, where that means flows, net issuance (IPOs and secondaries minus buybacks) and positioning, all of which, he said, “are closely tied to fundamental drivers.”
Not to spoil the suspense, but this debate will never be settled. Or perhaps I should say it’ll never be considered settled by those who are inclined to litigate it over and over again.
If it’s a bear case you’re after, Thatte suggested the better argument is far simpler than some of the more belabored attempts to quantify the likely scope of expected global liquidity contraction. “A modest pullback of 3-5% typically occurs every two or three months, and is arguably overdue,” he wrote.
