January 7, 2022
A belated happy New Year to those who peruse this page. This space has been negative on markets for so long, it can now be measured in years rather than months, and that has enough similarities to the classic story ‘The boy who cried wolf’, that the best solution was to stop spreading the pessimism.
As the new year approaches, it appears that some of the pessimism may be warranted, and if anyone was going to take action to protect against the excessive enthusiasm driving markets, now would be a good time.
As the COVID crash and subsequent rally unfolded (22 months of steady, unrelenting increases in market averages), the primary driving force was not ‘organic’ economics. The primary driving force was central bank liquidity. This has all been covered here for two years, but let’s highlight some key charts again.
Below is the chart of M1 – Money supply for the USA. M1 is a measure of how much money is moving about in the real economy outside of the Federal Reserve Banks. During the COVID crash, the bank has flooded the economy with money. The table below shows the magnitude in numbers. In January 2020, there was just $4 trillion of cash in the economy. In 2020 the market was flooded with $12 trillion and in 2021 another $4 trillion was added. That’s $8.2t per year on average. Certainly any expectations for markets to decline were mistaken.
|Year||M1 ($b)||Annual Growth|
All of this money had to go somewhere, and asset prices are rising. The data regarding household wealth is pretty compelling. Consumers are actually saving more during the pandemic. Here is a chart of deposits and currency for households and nonprofit organizations. I have used 2000 as the start level to help get a sense of what normal looked like before the 2008 housing crisis and the COVID crash.
Not only has the market been flooded with cash, but central banks have held interest rates abnormally low to ease strains on the financial system. This has led to a mountain of debt being taken on at all levels. The next chart, below is a view of total debt for all sectors since 1950. There are three key inflection points.
- The first around 1980, when Ronald Reagan reduced federal income tax and capital gains taxes (taking on debt to buy anything made sense!).
- The second around 2008 when the housing crisis caused a pause until interest rates were forced down by the federal reserve; and
- Finally, in 2020 when the economy was flooded with money
It is helpful to look at all of this in relation to interest rates and so the chart below shows interest rates from 1960 through until today. The largest over riding factor is the relentless march of interest rates from 14% to 0.25%. They cannot reasonably go lower, although negative rates are being tried in various countries to spur spending.
It is worth noting
- interest rates rose in 1980 (Reaganomics) which slowed inflation at the same time as tax rates were lowered. This inspired the debt binge which unleashed much working capital for businesses to expand.
- Interest rates rose in September 1987. The stock market crashed.
- Interest rates rose between April 1994 and April 1995. The stock market paused until the yield curve flattened in early 1995, then stock prices accelerated again.
- Rates rose sharply starting in July 1999 as stock markets ballooned. Some readers may remember the collapse of markets that started in April of 2000 and lasted until late 2002. (Markets were arguably saved by a collapse in interest rates.)
- Rates rose sharply again until the summer of 2006 when cracks began appearing in the housing market. The collapse began in earnest in October 2007.
- Rates did not rise above 1% again until December 2016 but then rose steadily to 3% through July of 2019.
- As stock market growth slowed in the summer of 2019, interest rates were dropped again and then, the COVID crash occurred starting in February of 2020.
- Since then rates have been held at 0.25%
On Wednesday (January 5th, 2022), the Federal Reserve released the minutes from their last meeting which highlighted that the central bank will reduce their buying of debt (quantitative easing) and the likelihood that interest rates will be heading higher very soon. In simple terms, they are going to stop flooding the market with liquidity.
When the central bank flooded the market with liquidity to save asset prices, it was clearly wise to invest heavily in almost any asset. The central bank and their policies didn’t just save the market, it boosted it considerably.
The question now should be whether it makes sense to pull money out of markets as the fed removes liquidity? Broadly speaking the answer is yes, the only problem is that all assets are expensive by historical standards, so what do you do with cash? That is for another day, but the downside risks are rising again, and the pressure is likely to last for a long time.
Despite crying wolf too many times, when markets decline, they often decline much faster than they rise and many, many market participants believe that asset prices are in bubble territory. The first leg down may come quickly and with little or no warning. Selling earlier rather than later may prove to be wise.