"Last thing I remember, I was running for the door,
I had to find the passage back to the place I was before,
'Relax' said the night man,
We are programmed to receive
You can check out anytime you like,
But you can never leave"
The Eagles - Hotel California
Against the expectations of another solid year after a stellar 2017, last year turned out to be fairly miserable for investors with every asset class significantly under-performing cash. In our regular year end survey in 2017, we found that consensus was expecting mid teen returns from EM equities in 2018 with not a single strategist calling for a negative return year for EMs. In contrast, MSCI EM ended the year down 17%, while the strongest of the markets like the US also suffered its first double digit losses this decade. The pain in risk assets was felt despite US GDP growth hitting 4%, global EPS rising to fresh highs (15% yoy growth), US corporates alone buying back ~1trn of equity and unemployment falling to multi-decade lows in US and Europe.
While there are various explanations to the sudden risk off (including possibility of a US recession in 2019), the most plausible explanation could be that the World is currently experiencing a liquidity squeeze. Post the Global Financial Crisis, we were in a slow deflationary recovery, prone to aftershocks (Eurozone periphery, China) which forced Central Banks to print money in vast quantities. It all started with the US Fed, but as the contagion spread to other economies, they also pursued large scale monetary easing. The result was 713 rate cuts, US$12trn of asset purchases and global bond yields falling into negative territory. In fact, 2017 alone saw a whopping US$2trn of asset purchases by the ECB and BoJ (the highest ever). Not surprisingly, it was this flow that conquered all risk assets, resulting in a stellar rally in global equities with preposterously low volatility in 2017.
However, 2018 marked an important turning point with the script changing from quantitative easing (QE) to quantitative tightening/tapering (QT). It is the US Fed which started withdrawing stimulus from last year, while both the ECB and BOJ continued with their asset purchases, but at a much slower pace. Consequently, total assets of major Central Banks peaked at $15trn in Mar-18 and has now fallen to $14.2trn at the end 2018 (chart 1). With liquidity getting scarce at the margin, assets that performed exceedingly well when liquidity was abundant (stocks, bonds, EMs) are now struggling, while assets that performed miserably under QE (cash, US$) are now outperforming. Moreover, volatility across risk assets has shot up significantly.
Chart 1: Total Assets of Major Central Banks
Source: Ed Yardeni Research
There are other factors which have amplified the recent equity market correction:
Debt funded share buybacks: Loose monetary and fiscal policy have led to unprecedented buybacks. Massive share buybacks not only have boosted EPS but have also led to reduced equity market float. Over the past decade, S&P 500 companies bought back ~$5 trillion shares. Less number of shares for trading means less liquidity. Less liquid markets amplify the market gyrations.
Side effect of the dominance of passive investors: Typically, active investors buy when stocks are undervalued and sell when overvalued. This active role has been critical, and the basis of mean reversion led cyclical investing. Relative to active investing, passive investing is more about momentum. However, as more and more markets are under the grip of passive investors the buying (liquidity) support which active managers tend to provide is now missing. This in turn has exacerbated the downward spiral in equities (especially in the US where the speed of the fall since October has taken everybody with surprise).
These technical issues are also in some ways offshoots of grand monetary experiment that various Central Banks have done at varied time periods since the Global Financial Crisis. However, what is now clear is that:
Peak Central Bank Liquidity = Lowest volatility (what we saw in 2017)
Liquidity withdrawal by Central Banks = Heightened volatility (what we are witnessing now)
While most Central Banks around the world have started to withdraw their liquidity support, there is one Central Bank which has expedited liquidity infusion since 4QCY2018. That Central Bank is the RBI. So far in FY19, the RBI has conducted purchases of government bonds to the tune of Rs.1.9trn via Open Market Operations (OMOs). Further, the RBI has stated that it will infuse another Rs.500bn worth of liquidity per month from January to March-19. Also, it mentioned that the “OMO amount stated above is indicative and RBI retains the flexibility to change it, depending on the evolving liquidity and market conditions” – basically implying a strong commitment to infuse durable liquidity.
Important to note that liquidity of such large magnitude has never been provided by the RBI ever before in its history. The last time RBI had infused liquidity of somewhat similar quantum was back in FY13 when it did OMO purchase worth Rs.1.5trn.
In our last article, we had argued that the recent decline in household savings in India meant that capital availability (liquidity) in the economy is likely to become a structural challenge. This year, the situation got amplified by the sharp rise in oil prices during middle of the year as well as the government crowding out the private sector. With respect to government finances, the need to support the farm/rural economy (in the form of loan waivers, higher MSP and direct cash transfer) is now acting as a permanent drain on the fiscal side. Lower than expected GST collections in the election year means that the Govt. is now looking for new and innovative ways to fund its spending program – and yet is likely to fall short!
As we know, the
oil led brief BoP shock caused a sharp decline in forex reserves which in turn led to the
decline in base money. Therefore, the RBI anyways had little choice but to generate sufficient reserve money in order to sustain growth. However, it was the ILFS default and the consequent shadow banking crisis that acted as a catalyst for the RBI to really step up its liquidity operations. While the RBI has been guilty of committing several policy mistakes in the last couple of years (and we have been critical of it), it is currently doing a commendable job of supplying durable liquidity at a time when the economy really needs it. The financial slack in the system is fairly limited as evident from the highest ever banks' credit to deposit ratio (chart 2). Also, the gap between call money rate and the repo rate along with corporate credit spreads continues to remain quite elevated despite the recent sharp correction in oil prices. This suggests that without the RBI’s liquidity support, economic growth will most likely suffer.
Chart 2: Record High Bank Credit to Deposit Ratio
Source: CMIE Economic Outlook
To conclude, the last few months have made one thing very clear. We are in an era where markets are overly dependent on Central Bank support. The design of the QE framework was that it will work mainly through the financial (asset prices) economy rather than real (capacity creation) economy. Therefore, when there is even whiff of withdrawal of quantitative stimulus the markets are reacting very negatively. The message from the markets is that the World is in QE trap and the foundations of the decade old expansion (post GFC) is on extremely shaky ground. Balance sheet normalization has been and will be a major challenge for all the policymakers. Markets would force the policymakers more than ever to continue to pursue loose monetary policy. Case in point is this Friday, when in response to weak Chinese economic data, the PBoC announced a RRR cut and even the Fed Chair Powell (despite a bumper labour market data) conveyed that the “Patient” Fed will be flexible with all of its monetary policy tools, including the all important balance sheet. In a nutshell, whether it is the RBI, Fed, PBoC, ECB or BoJ, the burden of heavy lifting squarely rests on their shoulders. They are riding a liquidity tiger and no matter how hard they try, there is no jumping of it!
