By Joseph Carson, Former Director of Global Economic Research, Alliance Bernstein.
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 it’s 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.
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