October 15, 2018
Paul Christopher, CFA, Head of Global Market Strategy
Liquidity Still Limits Market and Economic Risks
- When we ask whether the current economic expansion and the uptrend in equity markets can continue, the availability of liquidity is a crucial part of our answer.
- While the Federal Reserve’s steady interest-rate hikes may make credit less accessible today, as shown in chart 1, managers and households still have substantial (and even growing) cash stockpiles—for reasons that predate (or are unrelated to) the Federal Reserve’s policy changes.
What it May Mean for Investors
- We find that solid economic growth, low inflation, and healthy corporate and household liquidity all should help to insulate the U.S. economy from another 2008-style crisis. We still see a favorable environment for equities generally, and particularly for growth-oriented equity sectors (notably Consumer Discretionary and Industrials)—as well as for the Health Care and Financials sectors.
Along with the state of the economy, liquidity helps to drive risk appetite and the potential for financial-market advances. Liquidity includes cash, cash alternatives (such as savings deposits at a bank), and debt securities that can turn into cash quickly and easily. The problem is that liquidity is not always easy for investors to track.
Why does liquidity matter?
The U.S. economy is still growing. Yet, policy makers are raising interest rates, and measures of the money available for bank lending are suggesting declines. As the economic cycle becomes extended and credit availability tightens further, many businesses and households eventually will be forced to work down their savings and available cash. Historically, the more that unexpected events force investors to cover margin debt and oblige company managers to tap credit lines, the more that shocks can disrupt markets. As the U.S. economic expansion matures further, we expect liquidity to become scarce—leaving markets more vulnerable to increasingly significant price volatility. The question is whether that point has arrived yet.
Gauging the liquidity available to households and company managers
Credit may be less easy to access today, but managers and households still have substantial (and even growing) cash stockpiles—for reasons that predate (or are unrelated to) current Federal Reserve (Fed) policy.1 For example, record corporate issuance of new bonds since 2009 has exploited low borrowing costs. To some extent, bond issuance largely has replaced more traditional sources of business credit, such as bank borrowing. Largely because of this substitution, total business debt has grown below its 8% quarterly average (since 1952) in 34 of the 37 quarters in this economic expansion (since June 2009)2. A considerable portion of the borrowing proceeds is sitting in cash. Corporate liquid assets as a percentage of total assets was 17% in June 2018, near its highest share since 2005. This percentage could prove to be a peak, as other data since June indicate that a gradual drawdown in business cash is gradually emerging. Typically, businesses do begin to use more cash as the economic expansion matures, but that trend is still early and does not suggest an imminent problem.
For their part, households also hold significant cash. Households continue to save at rates close to their average pace dating back to 1952. What has changed since the 2008 financial crisis is that mortgage debt is growing more slowly than personal savings. It is true that credit card and auto debt are growing rapidly, but mortgage debt is the lion’s share of consumer debt—70% of the average household’s balance sheet since 19523. So, the mortgage slowdown makes total household borrowing modest and, importantly, slower than savings growth.
Chart 1 illustrates these trends. It shows total household liquid assets, including checking, savings, and money market deposits, plus holdings of liquid debt securities—essentially, assets that can be turned into cash quickly. Liabilities include all borrowing. Household liquid assets have outpaced liabilities since June 2015. While household debt trails savings, household liquidity is growing, even as the Fed raises interest rates. Rising household cash is still a significant support for household finances and a potential cushion against future shocks.
If the Fed interest-rate hikes choke off the U.S. economic expansion, or if China fails to add economic stimulus to offset the restrictions that arise from Beijing’s reforms, then we believe global liquidity conditions could truncate incomes and quickly drain reserves. In addition, if the U.S. and China head toward cutting off mutual trade, then the financial flows that pay for trade also would decline, and this could adversely affect the liquidity available for markets.
None of these is our base case. The fact that corporate and household liquidity is still significant should help to extend the U.S. economic expansion. Our economic outlook is for solid growth through 2019. We do not see a contraction in the coming 12 months—and probably through 2019 as well—and do not anticipate that monetary policy will change that outlook. Moreover, China is already stimulating its economy to counterbalance its reform program, and we expect an eventual trade pact. In an environment of solid economic growth and benign inflation, favorable household and we believe corporate liquidity should extend the U.S. expansion and help insulate the economy from another 2008-style crisis. We still see a favorable environment for equities generally, and particularly for growth-oriented equity sectors (notably Consumer Discretionary and Industrials), as well as for the Health Care and Financials sectors.