Tides of liquidity

‘…Men wrecked upon a sand that look to be washed off next tide’

Henry V

‘Share prices in Japan are floating on a sea of liquidity… US institutions are very liquid and their buying power will push Wall Street higher… UK equity prices are cheap by international standards and will draw increased support from cash rich overseas investors.’ Look at any international market commentary written in the past two years and you will have read something like this. Liquidity is perceived as the engine that has been driving the world bull market. But what is it, where does it come from, how has it affected markets, and will it remain a positive factor?

Liquidity is money that is uncommitted and mobile; spare cash in other words. Just like cash generally it can arise in only three ways. It can be earned, or borrowed, or it can be created. This is true whether you are looking at an average family or at a nation’s economy. For example, a family man with a steady income can save up liquidity to buy, perhaps, a modest Ford saloon. Or he can borrow to buy a more expensive Volvo, or thirdly, if the family is fortunate and owns other property, he can sell, say, a valuable antique and use the proceeds to buy a Mercedes. Knowing how liquidity arises is important if you want to forecast how it will be used.

Savings rates and the proportion of savings held in liquid cash vary hugely from one country to another and there are big measuring differences to take into account. Clearly the potential impact on the local capital market of a savings rate of 16%, as it is in Japan, will be greater than, for example, in the USA where the rate is currently 2%. Whether the absolute pool of personal liquid savings in a country is large or small, the underlying trend in personal incomes will broadly determine its rate of change and that is fairly predictable. Savings are not unimportant as a source of liquidity for the broad economy, but their marginal effect on stock markets has been overshadowed by the other sources.

Unlike that derived from savings, borrowed liquidity is inherently unstable. For it is not really cash that is spare at all even though it may be used as such. Take again our British family man with a house and a job in the home counties. Nowadays he can raise all the liquidity he wants by borrowing and with his bank encouraging him to do just that he has been borrowing on an increasing scale. Current UK retail sales figures and the yawning trade deficit in manufactured goods provide ample evidence of where this liquidity is going, and it also shows up in the massive over-subscriptions for privatisation issues. But at the end of the day the borrower will have to repay the liquidity and he cannot keep adding fresh infusions of debt indefinitely simply to maintain spending. House prices in the South East coupled with the golden micro-economy of the Square Mile, have created the illusion for some UK ‘investors’ of a party that need never end. It will, in fact, come to an end when City jobs and earnings come widely under threat and when incomes can no longer support the property values securing the debt. It is reminiscent of Latin America in the 1970s which bankers of the day thought had plenty of earning power to repay current debts and more besides. Borrowed liquidity is no more permanent for individuals than it is for nations.

Created liquidity is altogether a more complex matter. Central Banks literally create it by expanding the money supply. They do this by buying Treasury securities from the banking system, which enables commercial banks to release money from securities for loans thus adding liquidity to the real economy. In rather the same way as banks, individuals and financial institutions can create liquidity by converting other assets belonging to them into cash: the family man described above sells his antique furniture, a farmer might sell his land, or an insurance company might sell its Japanese equities. Because pure cash is only a tiny part of the global economy and total wealth, a general shift into cash out of other things can go a very long way. In Britain, for instance, cash now in circulation amounts to less than 4% of GDP.

Just such a shift into cash has been happening worldwide since 1980. It has been the shift of a lifetime and was so unexpected and rare an event that it has shaken the whole fabric of monetarist economic theory which depended on there being a stable relationship between cash and the broad economy. It started when Paul Volcker curtailed the supply of credit in the US banking system and the soaring price of oil and other tangible assets began to crack. Once the spiral of inflation was broken, cash was no longer something to be swapped without delay for hard goods. Instead, financial assets became a preferred store of wealth as a flood of liquidity forced down interest rates and equity yields.

Liquidity has not just been created by the personal sector and the banks, but by industrial companies too. For example, companies in Japan in the 1980s have slowed down their rate of investment in new plant as growth has slowed, and they have been left with piles of spare cash with which they have been speculating in their own stock market. Companies in other parts of the world have been buying in their own shares for cash and mounting huge takeover bids with borrowed money, thus creating liquidity which ends up in the hands of the shareholders. As cash balances have risen both in the US and the UK, banks have become eager to find new loan customers now that lending to the third world has become a commercial nightmare and the opportunity to lend for industrial and energy-related investment in the Western economies has declined.

So much for a recital of some of the ways in which liquidity arises, and perhaps it gives an insight into the cause of the rise in stockmarkets worldwide over the 1980s. Let us draw together the lessons of the past and form some conclusions about the future impact of liquidity on securities markets.

It has not been the mere existence of cash that has moved security prices, but its flow onwards into financial assets of all sorts. In the immediate future we see no reversal in the trend of moderate inflation worldwide and accordingly we do not expect there to be an outflow from financial assets overall. However, the bulk of the inflow into equities must now be over on any long-term reckoning of relative value comparing various stores of wealth, such as fixed-interest stocks, industrial raw materials, agricultural land property and energy on a world scale. If that is so the consequences for equity markets may be serious, because even though the inflow dries up, the supply of new equity paper does not. In Britain the £7 billion BP issue is about to descend on a market that will have to digest over £20 billion of new equity paper this year. Anxiety is already quick to surface, as it was at the time of the August trade figures, and when the returns which have come to be expected from UK equities fail to materialise, disappointment will set in. That is when the liquidity outflow will begin, and maybe it already has. All of a sudden basic value, ignored for so long, will matter again and money will flow to it. Given the real returns available assuming any likely inflation rate, fixed interest securities are of obvious attraction; UK gilts and US bonds, with yields now approaching 10%, can hardly be ignored.

When next you read about the flow of liquidity into equity markets, remember that the tide may be past its flood. Those unwary of the turn may soon find themselves stranded.

October 1987

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