The Five Pillars of Liquidity
Liquidity, that ephemeral beast. Much talked about, but little understood. There are five pillars of liquidity in the present environment. I used to talk about three of them, but I excluded two ordinary ones. Here they are:
- The bid for debt from CDO equity.
- The Private Equity bid for cheap-ish assets with steady earnings streams.
- The recycling of the US current account deficit.
- The arbitrage of investment grade corporations buying back their own stock, or the stock of other corporations, because with investment grade yields so low, it makes sense to do it, at least in the short run.
- The need of Baby Boomers globally to juice returns in the short run so that their retirements will be adequate. With equities, higher returns; with bonds, more yield. Make that money sweat, even if we have to outsource the labor that our children provide, because they are too expensive.
Numbers one and two are broken at present. The only place in CDO-land that has some life is in investment grade assets. We must lever up everything until it breaks. But anything touched by subprime is damaged, and high yield, even high yield loans are damaged for now.
With private equity, it may just be a matter of waiting a while for the banks to realize that they need yield, but i don’t think so. Existing troubled deals will have to give up some of the profits to the lenders, or perhaps not get done.
Number three is the heavy hitter. The current account deficit has to balance. We have to send more goods, assets, or promises to pay more later. The latter is what is favored at present, keeping our interest rates low, and making equity attractive relative to investment grade debt. Until the majority of nations buying US debt revalue their currencies upward, this will continue; it doesn’t matter how much they raise their central bank’s target rate, if they don’t cool off their export sectors, they will continue to stimulate the US, and build up a bigger adjustment for later.
With private equity impaired, investment grade corporations can be rational buyers of assets, whether their own stock, or that of other corporations that fit their operating profiles. Until investment grade yields rise 1-2%, this will still be a factor in the markets, and more so for foreign corporations that have access to cheap US dollar financing (because of current account deficit claims that have to be recycled).
The last one is the one that can’t go away, at least not for another seven years as far as equities go, and maybe twenty years as far as debt goes. There is incredible pressure to make the money do more than it should be able to under ordinary conditions, because the Baby Boomers and their intermediaries, pension plans and mutual funds, keep banging on the doors of companies asking for yet higher returns. With debt, there is a voracious appetite for seemingly safe yet higher yielding debt. The Boomers need it to live off of.
So where does that leave us, in terms of the equity and debt markets? Investment grade corporates and munis should be fine on average; prime MBS at the Agency or AAA level should be fine. Everything else is suspect. As for equities, investment grade assets that are not likely acquirers look good. The acquirers are less certain. Even if acquisitions make sense in the short run, it is my guess that they won’t make sense in the long run. On net, the part of the equity markets with higher quality balance sheets should do well from here. The rest of the equity markets… the less creditworthy their debt, the less well they should do.
July 24th, 20077:07 am at
David,
You omitted the various carry trades, usually funded mainly via yen, less so via Swiss francs or other low yielders (as distinct from the current account deficit recycling or Japanese retail investor diversification into high yielders). As far as I can tell, that trade is still extant, although the yen has been strengthening a little lately. David Rosenberg of Merrill had an interesting observation yesterday in that recently the yen has been a prime beneficiary of any flight-to-quality, as risky assets are liquidated and short yen positions covered. I believe that is the logic behind your previously disclosed long yen position. Just my two cents…worth about two yen now too…
July 24th, 200711:20 am at
Steve,
You’re right, I omitted those, and that is a partial oversight. Partial, because the carry trades as they affect the US are part of number 3. Globally, they are a separate effect, because you can look at how NZ is getting flooded with demand for its debt, pushing the currency up more and more.
So far we have not seen any large liquidation of the carry trade. We still have Japanese investors trying to make money off of higher interest rates abroad. But perhaps they will be the last to know?
July 24th, 200710:21 pm at
David,
I would actually argue that in Japan’s case it’s a separate effect, and not part of the recycling of the trade deficit, at least in part. True, the BOJ keeps rates low partially to make it unattractive to buy and hold yen (hence making it more difficult for Japanese exporters, and stimulating their GDP as a result). However, I would argue that this effect, and policy motivation, is separate from the recycling of trade flows. Even if the US trade deficit were lower, and USD/JPY traded stronger, I would suspect that the BOJ would keep rates relatively low compared to other G10 rates (although perhaps slightly higher from these levels) in order to stimulate the domestic (non-export oriented) economy of Japan.
As for Japanese retail investor flows, given the pressing demographic needs of Japanese society, I expect that they will continue to diversify into a variety of foreign investments unless and until the BOJ raises rates substantially, which seems highly unlikely at present. The global stretch for yield that you mentioned as Piller 5 is very real.
P.S. – As for today’s market, do you still have that Wayback Machine from a previous posting? I wouldn’t mind going back to yesterday and putting on a few hedges….
July 26th, 20077:01 pm at
Number 5 is interesting.
The baby boomers do expect ever so much from their children, cut off their job prospects and earning power and then some how expect that they will be able to afford the tax burden of their retirement, the pension and the health care…
July 27th, 200711:55 pm at
Liquidity more simply defined is the flow of credit from lenders (investors) to borrowers; it is the lifeblood of capitalism. There is never a shortage of borrowers so liquidity is controlled by the lenders and its availibility is reflected in exchange rates, interest rates and rate differentials. When liquidity is restrained markets correct, when it expands unrestrained, lenders will eventually disperse unacceptible risk into the derivatives markets where quants develop diversification models that underestimate risk resulting in mark to market and an inevitible financial crisis and a contraction in lending. The top of the cycle is close at hand when borrowers attempt to monetize their debt through the issuance of equity.