Global| Oct 26 2018Equity Market Selloff Resembles Liquidity Squeeze of 2000
|in:Viewpoints
Summary
The abrupt and sharp decline in equity prices in recent weeks has been largely pinned on the Federal Reserve as policymakers continue to move forward with their plan to raise official rates. Yet, the sell-off in the equity market is [...]
The abrupt and sharp decline in equity prices in recent weeks has been largely pinned on the Federal Reserve as policymakers continue to move forward with their plan to raise official rates. Yet, the sell-off in the equity market is much more complex and in some ways resembles the early stages of the liquidity squeeze and the high equity valuations of 2000. Here’s why.
First, according to my estimates, the market valuation of household holdings of real and financial assets topped 6.1 times the level of nominal GDP at the end of Q3 2018, exceeding the peak valuations that occurred during the end of tech-equity bubble (5.1) and the housing-bubble (5.8). History shows that asset markets are most vulnerable when expectations of business profits and market returns outrun the economy’s fundamentals for a long period. In other words, the markets have a lot of good news priced in and need a constant of flow of even better news and more liquidity to continue to run hot.
Second, the liquidity backdrop is deteriorating. My proprietary liquidity index, which was developed years ago by the Department of Commerce and is based on the growth in real broad money, the change in business and consumer credit growth and new flows into liquid assets, has slowed dramatically over the course of the past year. The slowdown in liquidity growth has been underway for almost a year and resembles that of 2000. That by itself is a major warning sign for the financial markets, especially for the high-priced growth stocks.
Third, the US economy is absorbing more and more of the liquidity flows to finance the sharp acceleration in nominal GDP growth. Through the year ending in the third quarter of 2018 nominal GDP growth is estimated to have increased 5.5%, which is nearly 200 basis points faster than the average of the Nominal GDP growth rate of the past 8 years of the expansion and the fastest growth rate since early 2006. A large part of the acceleration in nominal GDP growth is directly linked to the changes in fiscal policy as Congress raised defense spending and discretionary domestic spending by over $300 billion for the next two fiscal years and also cut business and individuals taxes.
The bottom line is that the wide swing in equity prices is driven by confluence of factors and the revaluation process has just begun. The most important factor is the concomitant decline and shift in liquidity flows. To be sure, the collision between monetary policy draining liquidity and fiscal policy transferring more liquidity to the real economy results in a double whammy for the financial markets.
While some of these characteristics were also present in the tech-equity sell-off of 2000 what makes the current environment different and more risky is that asset valuations are at higher highs and stance of monetary policy is far from being even neutral. Indeed, today the real federal funds rate is still close to zero, and in 2000 it was around 400 basis points. As policymakers continue to lift official rates its hard to see how that process of interest rate normalization does not lead to an additional squeeze on liquidity resulting in continued high volatility in financial markets, downward pressure on the market’s multiple and financial assets in general.
Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
Joseph G. Carson
AuthorMore in Author Profile »Joseph G. Carson, Former Director of Global Economic Research, Alliance Bernstein. Joseph G. Carson joined Alliance Bernstein in 2001. He oversaw the Economic Analysis team for Alliance Bernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income and ranked as one of Best Analysts and Economists by The Global Investor Fixed Income Survey. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Honorary Doctorate Degree, Business Administration Youngstown State University 2016. Location: New York.