Money Moves Markets

The Fed has effectively pledged its own balance sheet to prop up markets. There is no limit to the cash the Fed can print and its solvency is guaranteed by the US government’s tax-raising authority.

Global liquidity is plentiful, with G7 broad money growth running at over 11% pa – a 26-year high. Investors are currently frozen in the headlights but will rush to deploy cash as it becomes clear that financial armageddon will be avoided.

Equity markets are discounting a recession – their performance since the current economic downswing began in September 2006 matches an average of six prior hard landings. Bears need to believe that a recession is not only certain but will be unusually severe.

A hard landing may yet be avoided. The impact of tighter credit is counterbalanced by a significant easing of monetary conditions and US fiscal stimulus worth over 1% of GDP, with tax rebates due to hit pay-packets from May.

Corporations have been cautious about expanding employment and investment in recent years and are not yet under strong pressure to retrench. Emerging world resilience is a further bulwark against a severe economic downturn.

Investor pessimism is extreme – the CBOE put / call ratio has spiked above levels at prior US market lows, including 1998, 2002 and 2003, while bears outnumber bulls by the widest margin since 1990, according to the American Association of Individual Investors. US-based equity mutual funds have suffered a $21 billion outflow so far in March, according to Trim Tabs.

While retail punters are bailing, US corporate insiders have stepped up buying, suggesting they see value in their shares and do not expect a wrenching recession. InsiderScore.com’s buy / sell ratio has surged well above levels at recent market lows – see here.

Losses on US subprime mortgages have been largely accounted for. According to S&P, write-downs on subprime ABS could reach $285 billion, of which well over $150 billion has been disclosed. The $285 billion estimate far exceeds projected credit losses of $136 billion on underlying loans, reflecting both the creation of synthetic subprime exposure and distressed pricing. For synthetic subprime, losses for some participants are balanced by gains for others, while write-downs due to distressed pricing should eventually be reversed.

The magnitude and duration of the fall in US financial shares is comparable with the decline associated with the savings and loan crisis of the late 1980s. Financials are now trading on a larger price-to-book discount to other sectors than at the 1990 trough.

The G7’s malign neglect of the dollar now represents the key risk for markets. The Fed’s excessive interest rate cuts coupled with ECB / BoJ intransigence have prompted a flight of capital out of the US, exacerbating financial stresses. An associated surge in commodity prices has undermined efforts to stimulate the economy.