Contracting liquidity was supposed to pressure US equities during the dog days of summer and into Q4. It didn’t quite work out that way.

Stocks did sell off over that period, and meaningfully so, but not for the reasons some bears anticipated.

Instead of liquidity drain, it was a back-up in long-end Treasury yields catalyzed by the term premium’s dramatic, ~150bps ascent out of negative territory that undercut the equity melt-up.

Fast forward to November and stocks have largely recouped three months of losses to trade near YTD highs, adding to what I think it’s fair to call a frustrating year for bears. Bears like Morgan Stanley’s Mike Wilson who, as part of his year-ahead 2024 outlook, discussed factors which propped up stocks in 2023.

Wilson cited “earnings stability, cost leadership and operational efficiency” among mega-caps as the driving force behind cap-weighted benchmarks’ outperformance versus Morgan Stanley’s “fundamental analysis.”

But “Magnificent 7” leadership wasn’t the only factor. The liquidity backdrop was less onerous than anticipated, Wilson said, citing “a substantial injection of liquidity from three sources.” He went on to enumerate those sources as follows:

1. The bailout of depositors at several regional banks and the shoring up of other regional banks added roughly $500 billion to bank reserves. This support has offset some of the credit tightening from higher rates and provided additional liquidity to the economy and markets that may not have been available otherwise.
2. Treasury issuance was very limited in H1 2023 due to the debt ceiling constraint. This had a “crowding in” effect on markets, especially Treasurys and IG credit, which supported valuations of other risk assets.
3. While Treasury issuance has picked up materially since July, it has been skewed toward Bills and absorbed by the reverse repo facility. More specifically, this facility has been drained by over $1.6 trillion this year, mostly since June when Treasury issuance resumed. This is providing an offset to liquidity being drained by the Fed’s ongoing QT and elevated Treasury issuance.

The third factor speaks to the issue raised here at the outset: Treasury’s cash rebuild since the debt ceiling deal proceeded in “best case” fashion as RRP transformation found money funds rotating into bills, thereby absorbing the tsunami of issuance that might’ve otherwise drained liquidity.

The figure above is Wilson’s annotated 2023 liquidity chart.

In addition to disciplined cost-cutting / operational execution from the mega-caps and unexpected liquidity support, Wilson cited two other factors for equities’ resilience in 2023.

“The fiscal deficit increased significantly in the 12 months ended July 31 provid[ing] a major boost to the economic data, especially in the third quarter,” he said. That fiscal impulse “also eliminated the risk of a hard landing this year [and the] pricing out of recession likely led to the overshoot on valuation this summer.”

Lastly, Wilson said the “full impact” of the Fed’s tightening cycle is yet to manifest, even as market internals suggest a reckoning may be nigh. “One of the reasons the equity market’s breadth has been so weak this year is due to the impact of this monetary tightening that works with long and variable lags,” Wilson wrote. “It’s increasingly apparent that lag has arrived for the more interest rate-sensitive parts of the economy — both corporate and consumer.”