by Lance Roberts
AFP (Agence France-Presse) recently printed an interesting piece about the current illusion of permanent liquidity. To wit:
"Loose monetary policies have created an 'illusion of permanent liquidity' that is spurring investors to make risky bets and push up asset prices, the Bank for International Settlements said Sunday.
This "illusion" has not only been driving investors to make risky bets across the entire spectrum of asset classes; it has also led to the illusion of economic stability and growth. For example, financial analysts have started pushing the idea that the current earnings and economic backdrop will last for another decade. Such an expansion would rival the longest previous period on record (119 Months) from March of 1991 through March of 2001 during the "technological revolution." A repeat of such an expansion would be quite a feat if it were to occur. However, the drivers of declining inflation, interest rates and increasing leverage are no longer available to support such an expansion in an economy driven 70% by consumption.
This idea of "infinite liquidity," and the belief of sustained economic growth, despite slowing in China, Japan and the Eurozone, has emboldened analysts to push estimates of corporate profit growth of 6% annually through 2020. Such a steady rise in earnings per share would push levels to more than $183.00 per share. The problem, as shown in the chart below, is that such an earnings expansion has never occurred in history as it completely disregards the course of normal business and economic cycles.
(Note: The dashed lines show that earnings have a strong history of ranging, due to the business cycle, between 6% peak to peak and 5% trough to trough.)
It is unlikely given the current scenario of sub-par economic growth, excess labor slack globally and deflationary pressures rising, that such lofty expectations will be obtained. Importantly, it will be the consequences of such a failure that will be the most important. As the BIS states:
"The longer the music plays and the louder it gets, the more deafening is the silence that follows," Claudio Borio, who heads the BIS's monetary and economic unit, told reporters.
'Markets will not be liquid when that liquidity is needed most,' he warned, urging 'sound prudential policies (and) extra prudence on the part of market participants themselves.'
Many central banks have kept their rates at record lows and pumped their economies full of liquidity first to stave off recession during the financial crisis and then to boost recent anaemic economic growth."
There is a rising realization by Central Banks that these excess liquidity flows have failed to work as anticipated. The Bank of Japan entered into a "quantitative easing" program nearly 3x the size of that of the Federal Reserves most recent endeavor, or a relative basis, with nothing gained but a near 7% drop in economic growth. Domestically, the Federal Reserve's program has boosted asset prices that has inflated the wealth of the top 10% but left the bottom 80% in a worse financial position today than five years ago. (see "For 90% of Americans There Has Been No Recovery")
"Borio stressed that 'a common mistake is to take unusually low volatility and risk spreads as a sign of low risk when, in fact, they are a sign of high risk-taking. The illusion of permanent liquidity is just a prevalent now as in the past.'
Borio pointed out that years of 'unusually accommodative' monetary policy has left investors feeling secure low interest rates would continue or only be gradually tightened. That confidence has also spread to the international banking industry, where claims rose by $580 billion between January and March, BIS said. That marked 'the first substantial quarterly increase since late 2011.'"
The complete lack of "fear" in the financial markets can be seen in the levels of volatility across virtually all asset classes. The chart below, from Todd Harrison at Minyanville, shows volatility near their lowest levels on record for currencies, equities, and interest rates.
As Todd stated:
"Per the chart below, currency volatility, interest rate volatility, and S&P 500 volatility are compressed across the board. That makes sense in a world where liquidity is artificially infused into the financial fabric -- volatility is the opposite of liquidity -- but not so much as the punch bowl is being taken away. And it is clearly something that is on the radar of Federal Reserve officials given the interconnectedness of the global financial machination."
The illusion of liquidity and complacency, or should I say over-confidence, in the Federal Reserve has driven an unprecedented "yield chase" and an excessive disregard for underlying investment risk. The mistake that is currently being made by the vast majority of Wall Street analysts is two-fold. The first is the assumption that the Federal Reserve can normalize interest rates given the underlying deterioration in global growth currently. The second is that increases in interest rates will have ZERO effect on future earnings or economic growth.
As I discussed recently in "Don't Fear Rising Interest Rates, Really?" there has been no previous point in history where rising interest rates did not only slow the economy, but eventually led to an economic recession, market dislocation or both.
"While rising interest rates may not "initially" drag on asset prices, it is a far different story to suggest that they won't. I addressed this issue previously in "Why Market Bulls Should Hope Interest Rates Don't Rise" wherein I pointed out twelve (12) reasons why rising interest rates are a problem, particularly when those rate increases are coming from a period of very low economic growth.
What the mainstream analysts fail to address is the "full-cycle" effect from rate hikes. The chart and table below address this issue by showing the return to investors from the date of the first rate increase through the subsequent correction and/or recession."
The BIS is correct, the "Illusion of Permanent Liquidity" has obfuscated the underlying inherent investment risk. The belief that Central Banks will always be ready to jump in to avert a dislocation in financial or credit markets has emboldened investors to take on an incredible amount of risk.
The problem is that these excessive liquidity flows have only impacted the economic surface. Eventually, the underlying malaise will likely overwhelm the small beneficial effects of liquidity and a mean-reversion will occur. It is only then that investors will come to understand the gravity of the "risks" they have undertaken as the illusion of permanent liquity fades.