Markets Are All About Flows

This article looks at prospective supply and demand factors for financial assets in the New Year and beyond. Investors should take into account money flowing into and out of financial assets as well as stock flows, particularly escalating government bond issuance, which looks likely to accelerate significantly in the coming years. It adds up to the fundamental case for physical gold and silver.

At this time of year, the thoughtful soul considers prospects for markets. Pundits are laying out their forecasts, and they fall into two broad camps. There are brokers and fund managers who talk of value. Their income and assets under management depend on continually inflating prices. Then there are the pessimists, a ragbag of doom-mongers who sweepingly point to risks on a grand scale. The collapse of Italy, Deutsche Bank, China, Brexit… take your pick. Very few engage on the subject that really matters, and that is the underlying monetary flows into and out of financial markets.

We must assess the pace of monetary expansion relative to the demand for money and credit, and where that expansion goes. Early in the credit cycle, there is little demand from the non-financial sector for monetary expansion, so excess money and bank credit go into the financial sector, pushing up financial asset prices. As the cycle progresses, it begins to be demanded by the non-financial economy and money then flows from the financial sector to non-financials. This is why we have observed that just as business conditions in the real economy start improving, just as valuations begin to be vindicated, interest rates and bond yields start rising and shares enter a bear market.

It should be noted that while some shares are sure to rise reflecting specific corporate developments and investor focus, money draining from financial markets has the same effect as air draining from a leaking balloon. They deflate, and taken as a whole, prices of both bonds and equities persistently decline.

Interest rates begin to rise when the monetary expansion earlier in the cycle finds its way into the non-financial economy, inflating prices of goods and services instead of financial assets. More money ends up chasing the same quantity of manufactured goods and services, and their prices rise without an increase in demand. It is this effect which confuses those who can only equate rising prices with increased demand.

But for investors, the important effect of the evolving credit cycle is that it begins to limit the flow of new money into financials, relative to the money exiting into the non-financial economy. It is the balance of these flows which basically determines market values as a whole. The pessimists, many of whom will have been forecasting the imminent demise of stock markets through the whole bull run, at last, have a chance of being right, because of the knock-on effects of falling financial asset values. And it must be borne in mind that in the absence of new money flowing to support financial asset prices, there are always marginal sellers who will drive prices lower.

The supply of government debt will increase

Besides the ebbing away of money supply from financials into the real economy, we must also consider the effect of stock flows on financial prices, the most significant being changes arising from the financing of government deficits. In a conventional Keynesian economic model, the government stimulates the economy by deliberately engineering a budget deficit early in the cycle. As economic activity recovers, tax revenues improve, and government finances return to a surplus. Therefore, according to Keynes’s theory, demand for capital evens out over the cycle as a balance is restored towards the end of it.

This idealized setup is no longer the case. The last US budget surplus was eighteen years ago in 2000. Since then the US economy has had a bust, followed by a boom, another bust and in 2017-18 was in its second boom. The accumulated budget deficits since 2000 total $12.454 trillion and government debt has increased from $5.674 trillion to $21.516 trillion.[i] Whatever one thinks of Keynesian interventionism, the abuse by the US Government of Keynes’s theory of the state’s management of the economy is truly staggering, and seems set to drive it into a debt trap that can only result in either a severe retrenchment of state spending or the eventual destruction of the state’s currency.

So far, investors have ignored this underlying trend. They have happily taken the combination of zero interest rates and monetary expansion and invested in financial assets, including all the government debt on offer. The money and credit have been issued for them to do this, but it cannot continue forever. Monetary inflation has led to many governments adding to their debt obligations throughout the whole credit cycle, so the affordability to governments of future debt issues is bound to become an issue. 

The rule of thumb employed by economists in the past has been to compare growth in GDP with the interest cost of government funding. This presupposes that GDP growth leads to higher tax revenues, and as long as the increase in tax revenues is expected to cover the interest cost of the increased debt, the debt is deemed affordable. 

Governments have benefited from this relationship in recent credit cycles, not through increases in GDP, but through the suppression of interest rates. This is particularly dangerous because a debt trap will almost certainly be sprung when that unnatural suppression comes to an end. It also assumes that economic growth continues with little variation. It cannot apply to countries heavily exposed to the volatility of commodity prices, particularly emerging economies, nor is it viable in the real world of increasingly destabilizing credit cycles evident in consumer-driven welfare states.

The next two sections in this article will concentrate on the debt position of the US, on the basis that the dollar is the world’s reserve currency and international markets reference prices in dollars. An acceleration of debt supply from the US Government is likely to dominate global investment flows and financial valuations in the next decade, so we should try to quantify them. 

When considering the US Government’s debt, it must be noted that roughly one-third is held by the government itself in accounts such as the Social Security Trust Fund. However, they represent funding of external welfare obligations, so are external liabilities for the Federal Government. For the purposes of this debt analysis, they will be dealt with the same way as other public obligations, rather than as a purely technical internal government arrangement, which is the assumption of the Congressional Budget Office from which much of our information is drawn.

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Gary Anderson 3 months ago Contributor's comment

Another article warning of future bond #inflation. Sigh. #ArtCashin has said collateral demand keeps bond yields low, and that he is a yield bear. So far Cashin has been right.