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.