Liquidity in the Driver’s Seat with Central Banks Riding Shotgun
We've observed a growing chorus within the investment community that references one chart to explain stock market returns since 2013. This chart is believed to provide a framework for future stock market returns, with the prevailing message being that global (central bank) liquidity is the primary driver, rendering other analyses unnecessary.
The underlying logic from expanding balance sheets is that when central banks buy assets (and increase their balance sheets) they inject cash into global markets which can be used to bid other financial assets higher. Conversely, when central banks shrink their balance sheets they withdraw cash from markets, thus lowering cash available to purchase financial assets and potentially driving prices lower.
The commentary surrounding this chart has become so pervasive that we constructed our own indicator a few months ago, replicating this view (seen in the chart below), and continue to monitor its underlying components regularly. Given the high correlation between central bank liquidity, as defined below, and the S&P 500, it's evident why so many are paying attention.
Now that we have all seen the chart and internalized its message, does global liquidity truly hold the key to understanding stock market dynamics, leaving no room for other considerations? What about the Federal Reserve tightening cycle, rising interest rates and their impact on corporate earnings? How about the surge in investor awareness of the potential productivity gains from artificial intelligence (AI), or the visible earnings durability exhibited by large-cap US companies like Apple, Microsoft and Google?
Let us make a bold statement: markets are currently at a unique moment in time. When investors make such a statement, it is often simultaneously true and false. It is true because no circumstances driving equity prices are ever exactly the same. However, it is false because the uniqueness of the present moment is no greater than that of any other time when analyzing potential equity market returns; forecasting returns is always a challenging task.
Taking a Step Back and Assessing
Reasons to be optimistic about equity markets:
Reasons to be pessimistic about equity markets:
Furthermore, the US Treasury Department is about to withdraw approximately $1 trillion in liquidity from the global financial system as it refills the TGA (Treasury General Account) through the issuance of US Government Treasury Bills to investors, now that the US Debt Ceiling has been lifted.
Maybe our chart comparing Central Bank Liquidity versus the S&P 500 is all you really need to know.
Important Disclosures & Definitions
Central Bank Liquidity Index: US dollar value of Central Bank Total Assets (G5 (France, Germany, Japan, United Kingdom and United States) + China) minus [US Reverse Repo Facility Assets + US Treasury General Account Assets].
S&P 500 Index: widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
One may not invest directly in an index.
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than the performance quoted.
AAI000293 06/13/2024