Tis the week to reflect on the ending year and project on the year ahead. Investing through 2022 was historically difficult as equities and bonds both punished investors. Each one of us observed, learned and changed along the way. Now it is time to put that new knowledge to work.
This week we’re considering the implications of three dynamics that we believe are critical to the current tone and rhythm of the financial markets – and eventually the translation of those rhythms to the real economy. How these trends develop will tell us much about how to survive or thrive in 2023.
Liquidity is a measure of the ability to convert any asset to cash at scale and without changing price. The most liquid asset in the world is US Government Debt. So, when we start to see spreads versus fair value widen in this market the ripple effects can be enormous as illiquidity spreads. Over the course of 2022 illiquidity has become the most important risk we face. What is the real price of an asset? These issues have been primarily contained in financial markets, but as we end the year we’re starting to see illiquidity flow into markets like real estate and used cars. That bodes ill for overall economic activity and growth – perhaps that’s what the Federal Reserve (Fed) is aiming for, but it’s a blunt instrument, and often a good lead indicator for recession.
M2 money measures the money supply of liquid balances like cash, checking, savings and short-term CDs – the most spendable money available. For most of 2022 we have seen a decline in M2 supply. This is the longest period of declining money supply since at least 1958 and something we never experienced in the 1970s (an era we evoked often this year). This may or may not be a big deal – and that is why it’s such a critical risk. The monetary jet fuel from 2020 is wearing off – and just like we didn’t fully comprehend the impact of that flood, it’s very difficult to predict the effect of this drought. Like most droughts though, the longer this goes on the more permanent the damage to the economy.
There is no more important asset in the United States than residential real estate. It is the foundation for more “nest eggs” than any other asset, and it holds a place in our psychological wealth like no other. We view it as stable and permanent. When those assumptions are challenged, as we saw in extremes from 2007-2011, people change. We’re early in the trend of deflating housing, but it has begun. Like M2, this may be nothing more than a slight release of pressure of an over-inflated market. But releasing pressure from economies is not easy and still not well understood. Be aware that chaos and complexity rule – not equilibriums.
Liquidity of all sorts is under attack. In this type of environment keep your exposures tight, be patient and look ahead. The most prescient of the three charts above will likely be the US Government Liquidity Index. As this improves it should bode well for spreads across fixed income and optimism that the Fed is ending this flood-fighting era and it will be safe to extend outlooks and add risk. But not yet.
Important Disclosures & Definitions
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.
Bloomberg US Government Securities Liquidity Index: a gauge of deviations in yields from a fair-value model.
M2 Money Supply: a measure of the money supply that includes cash, checking deposits and easily-convertible near money.
S&P CoreLogic Case-Shiller 20-City Composite City Home Price Index: seeks to measures the value of residential real estate in 20 major US metropolitan areas: Atlanta, Boston, Charlotte, Chicago, Cleveland, Dallas, Denver, Detroit, Las Vegas, Los Angeles, Miami, Minneapolis, New York, Phoenix, Portland, San Diego, San Francisco, Seattle, Tampa and Washington, D.C.
One may not invest directly in an index.