With markets near all-time highs, we regularly get asked what on earth might be driving this. James Carville, the political strategist, famously declared, “it’s the economy!” during the 1992 presidential election campaign. So, in the case of the current stock market, we’ll say “it’s the liquidity!”
To put the current liquidity backdrop into perspective, if the $1.0 trillion physical infrastructure bill is passed, the U.S. will have spent approximately $6.0 trillion fixing an estimated $2.0 trillion hit to the economy caused by the coronavirus pandemic. That’s four trillion dollars of excess liquidity that is coursing through the economy currently. This doesn’t even contemplate the additional $1-3 trillion potential spend on social infrastructure that could add additional trillions to that already high liquidity figure. For reference, the size of Japan’s entire GDP is $4.9 trillion. Germany’s GDP is $3.7 trillion, India’s is $2.7 trillion, and the UK’s is $2.6 trillion. In other words, when all is said and done, we may have spent the equivalent of two India-sized GDPs in economic stimulus terms.
However, that is not the only government policy response providing liquidity to the economy. The Federal Reserve has expanded the size of its balance sheet from roughly $4 trillion to approximately $8 trillion since the beginning of the pandemic. While this is not a direct injection of cash into consumers’ hands, the expansion creates the conditions for very low interest rates, which reduces borrowing costs for consumers and companies and primes the banking system with copious amounts of liquidity, if needed. We’ve seen the impact of low interest rates on housing prices and the same pricing impact affects other assets such as stocks, commodities and, for that matter, bonds too, whose prices remain elevated, measured by their currently low yields. There is a saying that “every dollar must find a home somewhere,” and with real returns on conservative investments mainly in negative territory, clearly many of the additional dollars are finding their way into capital appreciation-oriented assets.
To be clear, earnings are recovering, the consumer is in good shape, companies have access to capital and innovation is alive and well, so what is the long-term cost of all this excess liquidity? The most likely outcome is that we are borrowing returns and economic growth from the future to ease the situation today. Today’s resulting high starting valuations, increased inflation and higher taxes will be the “friction” for lower expected returns in the future. Investors can adapt by looking at traditional asset allocation approaches differently. Security selection will be key. Event-driven investing opportunities with unique risk/return profiles will become more valuable to a portfolio. Quality should never be far from mind, in our opinion, regardless of the environment. Levering returns with borrowed funds and exposing yourself to the risk of permanent loss, however, is not the answer, in our view.
Liquidity has created a bullish backdrop for equities that could extend further than any of us can anticipate. But unless something has changed, there are still no free lunches on Wall Street. Periodic volatility should still be expected, but with liquidity like this, the buffet and free mimosas could stay open for quite some time and who wants to miss out on that?