Liquidity is one of the most confusing words in finance. The fact that it has multiple meanings, depending on the topic at hand, certainly doesn’t help matters. While we prefer to avoid that word, this is one of those times when it is unavoidable. In this case, liquidity is the amount of money sloshing around in the economy and there is likely to be less this summer. Stan Druckenmiller, one of the very best macro investors of the last 50 years, explains “Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks, and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.” More money is more liquidity, less money is less liquidity.
After reading that, you might wonder why we, and so many others, focus on earnings and free cash flow. The reason is that over the long term, earnings and cash flow growth create value and that value is ultimately recognized by the market. However, in the short term, liquidity often rules the day and the market looks to be facing some liquidity headwinds over the next several months.
The Response to COVID was to Add Liquidity, and Lots of It!
The power of liquidity has been amply demonstrated over the last few years. When the pandemic hit, the economy shut down. Demand contracted sharply; no one was out spending money, and the economy couldn’t maintain itself because the flow of money stopped. The stock market was pounded. In other words, there was no liquidity. Businesses had inventory, but no one was buying, so they could not convert that inventory into sales and therefore had trouble paying employees and paying debts. The economy came to a screeching halt.
The fear was that we would experience a 1930’s style deflationary shock. The solution was to add liquidity (money) into the economy in the form of cash payments to businesses and individuals – something described in economic studies as ‘helicopter money’. In America, if you give people money, they will spend it!
That waterfall of liquidity into the economy quickly rejuvenated demand for goods as we adjusted to COVID protocols and much of that money also flowed into financial markets sending stocks on a massive ride to the upside in 2020-21 (not to mention sparking inflation). This is a long way of saying that markets were unconcerned about earnings and cash flow and were reacting to the liquidity changes at the time.
The Relationship Between Liquidity and the Stock Market.
In the chart below, the blue line is level of the Treasury General Account (TGA), which, for the sake of simplicity, we will use as a proxy for liquidity. When the blue line is declining, the TGA is being drawn down, thus adding liquidity into markets. When the blue line goes up, the TGA is being replenished and it withdraws liquidity from markets.
The red line is the level of the S&P 500. Generally, when liquidity is added, markets rise and vice versa. With the TGA near zero due to the debt ceiling issue, expectations are that the Treasury will look to re-fill the TGA back to $600 to $800 billion, thus withdrawing liquidity and sending the blue line back up. Adding to the pressure will be the continuing $95 billion per month of quantitative tightening (QT) where the Fed allows its bond investments to mature, also reducing liquidity That implies that the stock market could be headed for a tough road this summer. The liquidity situation is substantially more complicated than we present here, but the result is the same.
What could change? The Treasury could decide to build back their reserves at a very slow pace or the Fed could reduce the level of QT. Nothing is set in stone, but suffice it to say that at the moment everything is pointing to less liquidity this summer and that should be a strong headwind for the stock market.
Liquidity was declining all through 2022 and markets reacted poorly. Many expected that trend to continue as the recession hit, but we were thrown off course in the first half of 2023 when the debt ceiling was reached in January, forcing the Treasury to add liquidity (draw down the TGA). Then the bank failures arrived in March and the Fed was forced to add liquidity into markets again to stave off a banking disaster. That’s more money being pushed into the system. The bottom line is that for the first half of this year, liquidity was being added, not subtracted as most expected and markets rallied in response. So, is this a new bull market? We think not. These liquidity headwinds should ultimately answer that question. As for the recession, the increased liquidity has merely delayed the economic response to higher interest rates and the onset of a recession. At this point, the evidence suggests that recession is delayed, but not avoided.
Of course, what is expected, and what actually happens are often two different things. Time will tell, but we expect liquidity headwinds to be a continuing story in coming months. The basic lesson is that more money out there implies better liquidity and friendlier markets, while less money out there implies the opposite.
What We’re Reading
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