The Aussie market is booming like it has never boomed before and the Aussie dollar is the strongest it has been in 17 years.
Retailing is doing very well, thank you,resources brilliantly (and for some time, according to a Reserve Bank paper, see below) and healthcare is booming.
Perhaps the only blot: the sluggish residential property sector and businesses servicing it.
But fueling the boom is cash. As the old adage says, ‘Money makes the world go round’, or rather these days it’s liquidity.
The AMP’s head of strategy, Dr Shane Oliver believes it’s the biggest influence at the moment and for some time to come.
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An often expressed view is that the surge in investment returns in recent years reflects a liquidity boom fuelled by easy money.
If the liquidity driven view of strong investment returns is correct then sooner or later it must all end in tears.
But it’s not so simple. While the liquidity backdrop for investment markets has been favourable, there is little evidence that asset prices have been pushed to exorbitant levels versus fundamentals – at least not yet!
What is liquidity?
“Liquidity” may refer to several different, but related, things.
1.The monetary environment – this largely reflects the actions of central banks, with liquidity normally thought to be easy when interest rates are low and money supply measures are growing strongly relative to growth in nominal economic activity.
2. The level of liquidity in balance sheets – are individual or corporate balance sheets cashed up with funds available to invest, buy shares, etc?
3. The operational liquidity of investment markets – this refers to the ease with which assets can be bought and sold without causing major shifts in current market prices. Markets tend to be most liquid in this sense when confidence is high and funds are flowing freely.
4. The demand for assets relative to their supply – some refer to the analysis of the potential sources of demand and supply for a particular asset classes as “liquidity analysis”.
For example, in the case of shares, key demand drivers are individual and superannuation fund flows and cash takeovers whereas supply is equity issuance less buybacks. Liquidity is high on this measure when potential demand for assets is high relative to their supply.
Of course, this concept of liquidity is largely driven by monetary and balance sheet liquidity, but it is also closely related to investor confidence. As such it is easy to confuse this concept of liquidity with changes in investor risk aversion.
The liquidity cycle and current state of play:
Liquidity normally follows a cycle that is related to the economic cycle. It’s easiest when economic conditions are tough – interest rates are low and balance sheets are cashed up.
It tightens after an extended period of economic growth as interest rates rise in response to inflation and companies and individuals allocate their cash to less liquid investments, leaving less to invest in the future.
While the economic recovery cycles in the world and Australia are now fairly mature and interest rates have increased relative to four years ago, liquidity conditions still appear to be favourable with no signs of constraints.
· Interest rates in most countries are below nominal GDP growth. This particularly so in Japan.
While broad measures of money supply growth in the US have been relatively subdued, they have been running above nominal GDP growth in the G7 economies as a whole and in Australia. Money supply has been rising versus nominal GDP in most countries.
Foreign exchange reserves are rising rapidly as various countries, notably in Asia and the oil producing countries, seek to prevent their trade surpluses translating into surging exchange rates.
The result has been strong growth in domestic liquidity conditions as money is “printed” to buy the foreign exchange and capital is recycled back into global capital markets.
Strong profit gains on the back of productivity gains have left corporate balance sheets in good shape with low levels of debt and high levels of cash.
This is fuelling capital returns to share holders, eg, via share buybacks and takeover activity, the proceeds from which are normally reinvested. It has also made lowly geared companies the targets of private equity firms.
The result of all this has been ongoing relatively favourable liquidity conditions for investment markets.
This begs the question – is monetary policy too lax?
Has “asset price inflation” simply replaced “consumer price inflation”? This a common concern, but the answer is no.
· Firstly, consumer price and asset price inflation are totally different concepts. The first is driven by the demand for and supply of goods and services in the economy whereas the second relates to the demand for and supply of investment assets. There are numerous examples in history where asset prices have gone up but consumer prices have gone down, and vice versa.
· Secondly, central banks have been doing the right thing by allowing money supply to rise faster than nominal GDP. Over the past two decades the world has been subject to a positive productivity shock driven by the combination of globalisation (reflecting the increased involvement of China and other emerging countries in the global economy), competition and new technology.
These have pushed production up and inflation down. If money supply had not been allowed to grow faster than nominal GDP we would have fallen into deflation and/or the pick-up in productivity would have been stifled.
· Thirdly, central banks cannot alone be blamed for relaxed liquidity conditions. Without an increase in the demand for money and credit it is not possible for a central bank to increase an economy’s broad measures of money supply and credit.
