Thursday, 5 October 2017

Stocks Face Strong Headwinds As This Pivotal Combo Plummets

If there is one thing QE1, 2, 3 proved (for those that didn't already know), it is this: money printing and the lower interest rates that result are both good for stocks and other financial asset prices. If we can therefore agree that a faster expansion of the quantity of money and lower interest rates are indeed good for stocks while it takes place, then we can perhaps also agree that the ratio between the two is of some importance for stocks. If you do, the chart below which depicts the year on year change in this ratio might just be of interest to you.

All else remaining the same, a higher reading is positive for a range of asset prices such as corporate bonds and stocks. Conversely, a lower reading is a negative.

Following the spike from August 2016 to March this year, the ratio has since fallen off a cliff despite the fact that yields on corporate bonds have actually dropped (which by itself should lead to a higher ratio). Why? Because the growth rate of the quantity of money has actually dropped at the quickest pace since the run-up to the 2008 banking crisis. This dramatic drop has thus brought forth a similar drop in the money supply to bond yield ratio below which now also is at a level last seen twelve years ago.

As asset prices, in particular bond prices and stocks, have clearly benefited from the surge in the money supply in the final quarter of last year and the drop (again) in corporate bond yields thereafter, the sharp falls in the ratio above should be of particular concern as one cannot expect bond yields to fall much further (they are at or near historic lows). In other words, the risk is that yields will rise, rather than fall, and pull the ratio above down even further. Hope therefore rests on a recouping money supply growth rate. However, absent QE4, a resurrection is dependent on increases in bank credit, the key driver of the money supply which has gradually declined all year.

But with the Federal Funds Rate and LIBOR actually increasing, and certainly not expected to decline any time soon, the prospects for bank credit growth faces headwinds. Not to mention that delinquency rates on Commercial and Industrial Loans, a major component of bank credit, is today twice what it was two years ago.

The stock market is therefore now quickly running out of the all important combination that have supported the bull market for year; a high money supply growth rate and falling interest rates. And with equity valuations at historical highs based on a range of metrics, current prospects for returns that sufficiently compensate for the exceedingly large downside risks are indeed dire.

For more on the theory underpinning the insights in this article, see:

The Austrian Theory Of The Business Cycle - A Short Synthesis

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