As it is a holiday here in Victoria and the Old Hat Factory is largely vacant, we take this chance to let someone else do our job. This from Dr. Marc Faber, in his latest Gloom, Boom, and Doom report, “At the end of each investment mania, investors believed in some sort of ‘excess liquidity’ that would drive the object of speculation forever higher. At the end of the 1970s, the ‘excess liquidity’ related to the OPEC surpluses; at the end of the Japanese stock and real estate bubbles, ‘excess liquidity’ centered around the enormous Japanese current account surpluses; during the 1990s emerging markets mania, ‘excess liquidity’ as perceived to come from foreign buying and the yen carry trade.”
Notice a pattern? Near the top of any investment mania, excess liquidity is always cited, in some form, as a reason for things to keep going up. Gone are the fundamental reasons (like stocks being cheap.) Liquidity arguments get louder. But it’s really just a fancy way of saying, “Investors will keep buying because investors have been buying, and they have money to spend, so they must buy something.”
Faber continues, “At the end of the high-tech boom the investment community believed that ‘excess liquidity would come from record mergers and acquisitions, a re-allocation of funds from bonds to equities, and easy monetary policies by the Fed (a belief that was fostered by the Mexican and LTCM bailouts and money printing ahead of Y2K.)
But as Albert Edwards of Dresdner Kleinwort explained in a January strategy report, “when markets are rallying but seem expensive, when new issues fly out the door and when fundamental analysis often appears to fail to explain events, the safe haven for the market commentator is to often to rely on the explanation that there is lots of liquidity.”
“Market liquidity remains strong and private-equity fuelled takeover waves appear to have some way to go,” said Guy Hutchings, chief investment officer of MFS Ltd. says in today’s Australian. David Uren writes about IMF officials who cite the high level of asset markets and attribute it to “the elevated level of global liquidity, supported by creation of new financial instruments and intermediaries.”
Okay. So private equity and integrated global markets are making it easier for huge sums of global capital to drive up everything at once. What next? Look for booming trading volumes, Faber warns. “Another common feature of the last stage of every boom was high trading volume, widespread public participation, high leverage, and money inflows into all kinds of money pools (Zaitech and Tokin funds, investment clubs, mutual funds, LBO funds, venture capital, private equity, emerging markets, art and collectibles, and equity, commodity, and index funds.”
“In this respect, the current asset boom is no different than previous investment manias, except that it includes all asset classes and is taking place practically everywhere in the world.”
What leads to the liquidity drought? Loss of appetite for risk. In that respect the hemorrhaging in emerging market funds is worth nothing. Also worth nothing is the slow, trickle-up of noxious sub-prime American mortgages, collateralized (collectivized) and packaged up as interest-bearing bonds to institutions (insurance companies, hedge funds, pension funds.) Investors may willingly choose to quit accumulating these risks. But there’s another risk.
If Moody’s, Fitch, or Standard and Poor’s re-rate sub-prime bond issues- something all the ratings agencies have been reluctant to do-it could force some institutional holders who can only own high credit-quality debt to sell. The re-rating wouldn’t just mean the down-grading of the credit quality of certain mortgage-backed bonds, it would also lead to a re-pricing of the bonds themselves, as they are marked to market value.
Uh oh. That’s when you find out just who’s been earning yield in the sub- prime market. And that’s when we find out how bad the sub-prime hit will be in the U.S. and elsewhere (foreign investors in U.S. markets are finding out they own mortgage backed debt, even though they may not have explicitly sought it out. Oops.)
Still, central banks have room to move on interest rates, namely down. You’d think they’ be reluctant to lower rates because of the effect that would have in the real economy, leading to more inflation. With labour markets already tight here in Australia, lower rates certainly wouldn’t help the situation.
If we know anything for certain it’s that these super cycles play out for much longer than you would rationally expect. Their conclusion seems inevitable. But getting there is full of unpredictable circumstances. Either way, citing abundant liquidity for continued growth in asset markets is one sign that we’ve entered the last manic phase of the Super Bubble. The only question now is if it last eight days, eight months, or even longer.
Meanwhile, both Australian and South African gold production fell last year. The United States jumped past Australia to second on the list of the world’s largest producers. We will ask our gold-minded lunch companions today what they think this means and report back to you tomorrow. Until then…
Markets and Money