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FRIEDBERG'S COMMODITY
AND CURRENCY COMMENTS
Prepared by Friedberg Mercantile Group
Liquidity Is Just A State Of Mind
We often hear that financial asset prices cannot go down because there is so much money “out there” or “sloshing around.” The more colorful types have even spoken of a “wall of money,” conjuring up pictures of rivers and torrents of money washing off the shores of Wall Street. Can this be true in a real sense? Is there so much more money today than there was 5, 10, 15, or 20 years ago? Before we answer this question, we need to draw an obvious and simple distinction–one between stocks and flows. Money supply, narrow or broad, is a stock. Wealth is a stock. Changes in money supply are flows and so is GNP, or national income.
Money flows in recent years have been rather moderate, with the broad stock of money rising on average by not more than about 5% per annum. In dollar terms, M2 rose less than $20 billion over the past 12 months, a figure that pales in comparison with, say, Ted Turner's billion dollar increase in net worth (via his holdings in Time Warner) over the past 9 months. More comparably, the $20 billion increase in M2 is still much smaller than the $25 billion or so that flow monthly into U.S. mutual funds. Here one may justifiably ask, from where? And the answer is crucial to an understanding of today's liquidity crux.
Very simply, people's aversion for risk has progressively diminished. This is both a result of and a cause of the longest bull market in history. With the diminution of risk aversion we have witnessed a massive and historic shift of funds from fixed-rate to variable-rate returns that has created the impression of a veritable tidal wave of money. The greater risk-seeking activity of the public has naturally lifted stock prices, and the price of lower-quality credit instruments; price-earnings ratios have soared, and credit spreads have collapsed.
What caused this paradigmatic shift in risk appreciation? Three factors, in our view.
First and foremost is the sharp fall in nominal yields that began with the end of the Great Inflation in the early 80's and was accelerated by the Fed's super-easy monetary policy in 1992-93. The “sticker shock” phenomenon (refusing to renew maturing deposits at lower and lower yields) of the early 90's assumed, correctly in our view, that the public was unable or unwilling to differentiate between falling nominal and relatively stable real yields. Admittedly, there is little doubt that at some point\in particular 1992-93\the public sensed that real yields were negative.
Second, the persistence of the bull market of the 80's, which was only catching up to the huge asset inflation of the 70's. Its durability began to create, among the younger generation, the impression that equities could only go up. Thirdly, the Mexican bailout, a signal that the-powers-that-be would never allow a major emerging economy to fall and much less a localized financial crisis from spreading globally.
“Moral hazard,” as economists like to call it, provided a powerful incentive to step down the slippery slope of risk aversion, with the result that hundreds of billions of dollars have flown from developed countries to less developed ones in just three short years.
Liquidity with respect to speculative assets is no more and no less than the willingness of investors to step up to the plate and accept greater risks. Conversely, illiquidity occurs when routine sellers find buyers backing away from accepting greater risks. In the former case, speculative positions can be sold at rising prices; in the latter, speculative positions can be sold only at declining prices.
Liquidity and illiquidity, then, are a function of willingness to accept risk. They are states of mind. It matters little how much new money is created or even how much money is destroyed, the equivalents of money supply growth and contraction respectively. The feeble $20 billion annual increases in broad money supply is irrelevant to our discussion of liquidity.
It is interesting to note the growing share that common stocks are taking in the liquid portfolios of the U.S. public: In the months before the crash of 1987, common stocks represented 65% of the combined value of M2 plus common stocks. Now the proportion of common stocks to total liquid assets (M2 plus common stocks) has grown to 72%. The public holds now 2½ times more common stocks, at today's prices, than currency, checkable deposits, and fixed-term deposits. This is no mere curiosity, as wealth represented by common stocks is variable and only as good as the last ticker tape quote.
Digressing a bit further, we also note that the savings rate in the U.S. has declined to the lowest level in 50 years, clearly on the back of this dramatic rise in wealth. But at the risk of overemphasizing the point, wealth is far less reliably secure in September 1997 than in July 1987.
One might be tempted to ask whether, in fact, a relationship exists between the value of all common stocks and M2 type deposits beyond which one could safely predict that a limit has been reached. The answer of course is negative. As long as the holders of these deposits are willing to accept progressively greater risks, a roughly unchanged stock of money will be able to support higher and higher valuations of variable-return assets. Note that money going into common stocks does not vanish into a black hole. It reappears in the balances of the seller. The money stock is simply recycled.
The state of mind that causes the fabulous liquidity that we enjoy today can change only when bets begin to go awry and losses begin to mount. This is the significance that the Southeast Asian crisis has acquired.
The crisis has impaired the capital of a very large number of emerging market players and has done so beyond their wildest imagination. As the crisis spreads\and as sure as night follows day it will\to the Japanese banking system, already tottering on the brink of insolvency, to Colombia, Brazil, and then the rest of Latin America, and finally to Central Europe and Russia, the willingness to take today's risks will diminish.
As consumer credit losses continue to mount, the willingness to make loans at today's spreads will diminish, too. As consumers, starved out of credit, retrench, corporate loses will mount. Mounting losses will dry up liquidity on a global basis, even without the Fed lifting a finger, or hoisting rates. With investors turning tail, liquidity will vanish, and shares, and low grade/high-yield securities will need to be marked down. As security losses mount, illiquidity will become critical, and only the best and the safest (Treasury securities?) will survive and prosper.
The “wall of money” is not real. It is a product of our animal spirits.
September 28, 1997Friedberg Mercantile Group
181 Bay Street, Toronto, Canada
Copyright 1997, by Consensus Inc. All American and Pan American rights Reserved. editor@consensus-inc.com
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