E Shrinking Global Liquidity Raises A Red Flag In The Equity Markets

Source: Yardeni Research, January 10, 2019

What are some of the signs that the decline in liquidity is having an adverse impact on the U.S and world economies? Overall, there is now a clear recognition that economic growth in all the major economies is slowing. Equity markets are skidding since late 2018 as investors downgrade their expectations for profit growth. Companies with high levels of debt depend on liquidity to re-finance and expand operations. The yield curve has flattened in the US Treasury market, a sign that investors do not anticipate inflation reaching or exceeding the targeted 2% figure in the next 3-5 years.

As liquidity become tighter, there has been a sizable drop-off in corporate borrowings from investment grade to junk bonds. Since the 2008 crash, the corporate sector has relied on these borrowings to support investment in new plant and equipment and other business infrastructure. Firms borrowing in the high-yield bond market are also among the most sensitive to changes in financial conditions.

(Click on image to enlarge)

Source: Bloomberg Barclay’s Index

As liquidity everywhere shrinks, corporate bond spreads widen. This makes it much more difficult for new issuers to come to market. A credit spread is the difference in yield between a US Treasury bond and another bond with the same maturity, but with a lower credit rating. If spreads widen, it means investors want more compensation for the risk of lending to a company rather than to the US government. The situation could also be particularly acute for BBB-rated bonds, the lowest-rated bonds on the investment grade spectrum. According to David Rosenberg of Gluskin, Sheff, the biggest risk to the equity markets is widening credit spreads. He rightfully points out that Investors should remember that liquidity tends to dry up in a bear market, especially in the latter part of a credit cycle such as we are experiencing now.

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Gary Anderson 4 weeks ago Contributor's comment

I am listening to Mike Mayonaise Mayo telling us on CNBC that consumer credit is just fine. How does that reconcile with your research, Prof?

Norman Mogil 4 weeks ago Author's comment

My point is that on the corporate side, which means "investment" in the GDP component, money is getting tighter and more expensive. That segment has been increasing debt levels without an commensurate increase in output ( the marginal productivity of capital investment has been falling). We know that the tax cuts did not go into debt reduction or into growing the capital stock--- it was rewarding shareholders. So, the existing debt needs to rolled over and new debt is needed for new investment. Now, the central banks are making matters worse. and that is reflective in the spreads and the deteriorating quality of the lender. Today, Gundlach argued that about half of BBB bonds, the lowest segment of investment grade should be downgraded to junk which tells you how bad is the quality of debt. That would result in more liquidation by funds who cannot hold junk debt. Remember US corporate debt stands at $6 trillion so there is a lot of debt to negotiate out of.

Gary Anderson 4 weeks ago Contributor's comment

Prof, there is a debate as to whether the Fed is tightening or not. GDP seems to be holding up. My question is whether you think the bad bbb and lower debt is massive enough to reflect that the Fed is indeed tightening, or is it not significant enough to prove tightening?

Norman Mogil 4 weeks ago Author's comment

I am not sure how else one can interpret that sucking out $50b a month as anything other than tightening. Bernanke warned against shrinking the balance sheet until interest rates were ' normal' --presumably much higher than today's because the normal rates would signal that growth was strong and tightening would not slow growth. However, the Fed started that process too early and the equity markets are not suffering from this withdrawal and from trade policies gone amok and China sliding. So, maybe the bad BBB debt is caused by the trade fight or by general slowing. Regardless, withdrawing cash from the system is not helping.