Liquidity And Faith In Central Banks

As a market participant intently focused on global equity indices, the idea of a seasonal ‘melt-up’ into the new year is playing out beautifully. While we should respect price above all else, as a macro-discretionary guy, I am always keen to know why something is going from A to B, so I can focus on the ‘why’, to help with understanding the probability of it going to C.

I have put a collection of charts (click on them to expand) together, which form the basis for a presentation I am doing in London today, which goes some way to explain why we are seeing such limited pullbacks and positively trend markets.

Firstly, we must consider the performance of global equities this year (in own currency terms), and this before we look at total return.

  • S&P500 – +25%
  • NASDAQ 100 – +30.1%
  • FTSE 100 +9.9%
  • EU Stoxx – +23%
  • Nikkei 225 – +17%
  • ASX 200 – +20.1%
  • CSI 300 – +29.1%

As Goldman’s highlights, the percentage of large-cap funds outperforming their benchmark – this is US-centric, so assume they are benchmarking to the S&P500 or an MSCI index – is around 28% or so.

% Large Caps

Its fair to say FOMO, and the need to be paid, is a dominant driver of this market. If you are an active manager, and the index is going up you must be involved. Short interest (as a percentage of market-cap) and cash on the sidelines would clearly be low right now.

US500 – The trend is clearly strong and mature, so CTAs would be all-in, although, we are pushing on trend resistance – a break here would be obviously bullish into December.

Russell 2000

US2000 (Russell 2000) – One of the must-watch set-ups in equity land. Small caps breaking out is undeniably bullish as a guide to semantics, and the index looks to establish a new trading range or even a bullish trend. How price reacts in upcoming trade is key.

US2000 Weekly

S&P 500 (yellow) vs BBB credit index (white) – We do see periods of divergence between these two variables, such as we saw in early 2018, and we ask why.

And, after two years of a strong correlation, we are seeing an ever-growing divergence between equity and credit. BBB credit is the lowest tranche of US investment-grade corporate debt, and one concern for 2020 is that these corporates have amassed around $4t of debt.

Around $1t of debt is from US corps with a rating of BBB-, so that is a huge amount to be owing if we see economic fragility, where we will inevitably see a wave of rating downgrades, which takes these firms out of investment-grade and into high yield.

Equity, in my opinion, will absolutely notice this.

The fact that credit has not seen the same enthusiasm as equity here, at least in the poorer quality end of town, is a bit of worry.

S and P BBB Index
(Source: Bloomberg)
If we look at the year-on-year performance of S&P500 (blue) vs Citigroup US data change index (the index goes up when data is beating), we see the index has lost its connection with US economic data trends.

Citi SPX

Granted we have seen a slight improvement in the ‘global economic policy uncertainty index’ (Baker, Bloom, Davis), as trade headlines have shown some signs of convergence, at least on Phase One.

However, global data is largely missing expectations, as measured by Citi’s global economic surprise index. Equities are not too concerned by data.

Global Economic Policy Uncertainty Index

Liquidity Is King

  • Red – The G3 (US, Europe and Japan) central bank balance sheet (BS)
  • Pink – global money supply
  • White – MSCI world index
  • Orange – Fed funds rate

Global Money Supply

The expansion of the Fed’s BS, amid ever-higher levels of money supply, presumably driven by China, seems to be the driver of equities. Liquidity, as they say, is the oxygen in the lungs of markets.

The chart from Citi, tells a clear story. The change in the MSCI world (equity) index vs total central bank purchases:


In fact, the 10-week change in the Fed’s balance sheet, mostly to keep short-term rates in check through its much-publicised repo operations, is growing at the fastest clip since 2009.

There is certainly a sizeable take-up from the street to lock in year-end funding, but this is having the effect of a rapidly expanding BS .

Consider that in Europe the ECB’s BS is a mere €17b away from an all-time high and sits at an insane 40.6% of GDP.

Fed Balance Sheet

(Source: UBS)

Implied volatility has collapsed, in all asset classes. In this chart, we see FX implied volatility (red), equity vol (VIX index – white) and bond vol (orange). We also know there is a record short position in VIX futures, although that is not a reason to expect a break higher in volatility (vol). The lack of vol just means the volatility-targeting hedge funds are all in on this rally, as the level of investable capital, dictated by the level of vol across asset classes, can be far higher.

FX Implied Volatility

It seems that the data and news flow is just good enough to allow the market to focus on the two main drivers – FOMO and liquidity. If liquidity dynamics change the market trend could as well. In central banks we trust!

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