Fed is not the only source of excess liquidity in the system today. Private Equity is another key source.
Global Equities: A dramatic rediscovery of risk
2020 is looking like an insane year of markets ups and downs, and we are only halfway through it.
The COVID proved to be a perfect ‘black swan’, a ‘Minsky moment’ that no one could have foretold coming. The equity markets collapsed from historic high levels in late-February. S&P 500 lost 35% of its capitalization in less than a month. As shown by the chart below, the magnitude of the correction was quite comparable to previous similar periods of stress including those that led to sharp corrections in 2010, 2011 and more recently in 2018. The speed of the crash however has been the fastest we have seen in recent history.
A full closure of the economies is something that we have most probably never experienced in our lifetimes. The current consensus looking at a c.45% contraction in the EPS of S&P500 for 2Q20 and a 25% contraction for the full year 2020. The cascade of disappearing sales across multiple sectors and industries is likely to have led companies from industrial, consumer discretionary and even technology to draw all credit lines and tap into all possible sources of cash.
On the positive side, there is overwhelming optimism on reopening of the economies and generous injections of liquidity by FED and other central banks. This has provided a bottom to the equity markets downfall through late-March. Once again the magnitude is similar to previous post-recession pickups, but the speed remains phenomenal. S&P 500 is up 40% from the March ebbs and that settles the year-to-date performance to almost flat – as if the COVID never came…
The recovery has lifted most boats, and that is leading to a progressive improvement in the market breadth. With initially selective market action favoring quality, defensive and growth, the increasing participation of more economic-sensitive and cyclical pockets of the market is a recognition of diminishing P&L concerns and cashflow risks in the coming quarters. Growing confidence globally has led to a cyclical rediscovery of risk.
Retail gasoline demand is an excellent barometer for an anticipated economic recovery process. As shown by the chart below, it has improved steadily for 6 weeks, but remains -26% below normal levels and offers further improvement potential.
Excess liquidity in the system is working as a backstop for equities
Aggressively accommodative central banks, private equity folks with their dry powder being deployed and banks giving out the eased capital buffers as credit are effectively backstopping liquidity crisis.
Global central banks have moved forward at a speed and scale of the response not seen. Most probably some key lessons have been learnt from a slow and insufficient response provided during GFC. US alone is rolling out a c.10% of GDP, Germany 22% of GDP and France 14%. Such aggressive responses have been effective in easing fears of pressure from liquidity and solvency.
But the show is not yet over. A Bloomberg chart that we came across a few days ago caught our attention. It pointed at the level of liquidity in the market, charting the ratio of the Fed’s balance sheet (& money supply as in M2 index) along with the S&P 500’s market capitalization. The ratio of S&P 500 market capitalization to Fed’s M2 money supply has broken down the 20-years average. A situation rarely seen in the recent history. The above chart points at the relatively low current valuation of the equities index when considered in view of the level money supply in the system. Will S&P’s market cap be able to catchup with the Fed’s aggressive assets buying of late?
It is also important to note that the Fed is not the only source of excess liquidity in the system today. Other players in the market including Private Equity entered the COVID crisis with sizeable ‘dry powder’. According to independent sources, there is some $1.5 trillion of dry powder in the vaults of the PE that is progressively making its way in the system. Most importantly, this is the money that is likely supporting the most vulnerable small businesses and backstopping their bankruptcies. In the end working as a confidence booster for the financial markets.
Another source of liquidity in the system is the banks. In a much better shape today versus the 2008 GFC, and with regulators progressively lowering capital requirements as of late, the banking system is likely ready to deploy freed up capital to provide a necessary lifeline of credit into the system. It is estimated that nearly $0.5 trillion of capital has been freed up globally, and a large portion of it should be making its way to the small businesses.
What are the risks
Hong Kong once again making the news, with political rhetoric volley ball between Trump and Xi regarding the region’s ‘favored status’. Moreover, the local anti-china protests are a reason of concern for global markets. A gateway to China for an access to international capital markets, Hong Kong is strategically critical to China, especially to a highly levered up China. A significant portion of this leverage has been accumulated using Hong Kong as the main channel to tap in international inflow. While Hong Kong has a nearly $30 billion trade surplus with the USA, and there are an estimated 1500 American businesses with a local Hong Kong presence. For Trump, beating up the Hong Kong mantra is far less counterproductive to the US businesses versus trade sanctions and barriers.
Hopes for a vaccine run high, and these are well reflected in the latest market action. However, any disappointment on this front could quickly derail the stock’s performance.
Latest protests from BLM activists, and violence on American streets is worth mentioning for an election year. If this starts inciting troubles for businesses and the stock markets, Trump will be accommodative and dialogue with the masses may do some cosmetic equal rights resolution to show his commitment.