Why have stocks gone up?
In this short edition of What’s Up with Stonks, let's about the recent inflation data, which is uncomfortably persistent. Then we will look at the reason behind the stock market rally of recent months, namely liquidity developments. Central banks are not quite as tight on monetary policy as they appear to be.
Inflation is too sticky
On Tuesday, inflation data from the US came in broadly in line with expectations The consensus of economists expected annual inflation to ease to 6.2%, when in fact prices generally rose by 6.4%. However, it is 0.1 percentage points lower than in December. On a monthly basis, prices rose by 0.5%, which is the fastest pace in a while, driven by energy and shelter costs.
As all my active readers know, the cost of shelter is a lagging indicator because of its methodology. Looking a little further below the surface, prices for services excluding shelter rose by 0.3% per month, as this curve shows. What is worrying, however, is that price rises are still widespread. At the same time, one can only wonder how China opening up and the better-than-expected performance of the European economy will affect the global inflation picture.
The Atlanta Fed's measure of sticky core inflation shows prices continuing to rise at an annual rate of 6.6%. The 3-month annualized rate also accelerated to 6.2%.
When you consider this inflation data, and an economy that has surprised us with its strength in recent months, the Fed's rate cuts this year become a fantasy. This graph shows the current market expectation for the policy rate in December. With strong labor market data and hot inflation data, it has jumped to over 5%. Of course, it's worth bearing in mind that with new data these expectations will swing here and there, but for now this is the best guess as to the future level of policy rates. Of course, for the long-term investor, these factors matter only to a limited extent. Inflation and interest rates will come and go, but the value creation of quality companies will remain.
Why have stocks gone up?
Why have shares risen since last fall? Of course, the more interesting question for investors is where stocks are heading in the future, but it doesn't hurt to reflect on the drivers of past performance every now and again. Familiar explanations include the recent positive economic surprise and the slow decline in inflation. The direction is right.
Even more strongly, the rise in equities may be driven by an improved liquidity situation. Despite high interest rates, the abundance of money in the world has actually increased quietly in recent times. Two months ago, I discussed how the liquidity situation had reversed earlier during the fall. Now is a good time to look back at this development.
The two most important central banks in the world, the US Fed and the People's Bank of China, have been splurging money more or less visibly.
This graph shows the evolution of the Fed's net liquidity and the S&P 500 index. It's no coincidence that the two have been heading in the same direction. The Fed's net liquidity is calculated by subtracting from the Fed's balance sheet total those items that don’t actually feed the system's money supply, i.e., reverse repos and the federal current account at the Fed. I dealt with these obscure items in a previous post. Although officially the Fed has been shrinking its balance sheet for almost a year, calculated in this way, liquidity hasn’t shrunk significantly since last summer. In practice, the depletion of the federal account and the fall in the number of reverse repos have compensated for the shrinking balance sheet. I put a link to this graph here if you want to follow the evolution of online liquidity yourself.
According to Michael Howell of CrossBorder Capital, who has been tracking the liquidity, the Fed was spooked in the fall when the UK bond market almost went belly up because of thin liquidity. If a similar mess were to happen in the hub of the financial system in the US, the effect would be felt globally. In addition to price stability and maximum employment, the Fed's role is to maintain the stability of the financial system. I think the stakes are highest in the latter.
This may sound counterintuitive. The Fed, while raising interest rates, is still around the corner from being more generous with the rising liquidity. But these are different tools for different problems. At the same time, the Fed can oil the frictionless gears of the global financial system with its balance sheet measures, while in turn hitting inflation with its interest rate hammer. In a recent interview, Howell argues that interest rates may remain higher for longer, but the bottom of the liquidity cycle is behind us. This is, of course, welcome news for owners of risky asset classes such as equities and cryptocurrencies. Perhaps this is part of the reason why equities have done well in recent weeks, even though the economic heat would lead you to believe otherwise.
The People's Bank of China has also injected a record amount of liquidity into the economy recently. This CrossBorder graph shows the central bank of China's liquidity injections alongside momentum which indicates economic growth. The splurging has calmed down in recent weeks, but no wonder the stock market is happy with the two main central banks stimulating the markets.
Thank you for reading the post! Read analysis and make good stock picks!