Follow the Money – Understanding Policy Lags…

This post tries to map out how liquidity is supplied into the real economy.

When a commercial bank makes a loan, the borrowers’ bank accounts are credited by the amount of the loan credited (i.e. money is created). A lot of money was created in 2020/21 as a result of COVID-19 and has caused price levels to rise across goods, services, and assets. Money can also be created via central bank debt monetization.

Money growth in 2020/21 grew at over 3 times the amount of trend growth of money – no wonder we see consumer price inflation at 4 times the amount of the inflation target. As you will see, trend growth of money tends to grow at a constant rate over time to help ensure aggregate demand meets supply across the business cycle.

The outcome of the supplied liquidity including Real GDP growth, corporate profits, employment and consumer prices, is the focus for most investors, which are all key measures of the health of an economy, rather than money/credit growth.

Very few people focus on monetary aggregates and credit growth and we believe that newly supplied liquidity drives the economy forward and helps to refinance old debts to maintain the stability of the existing system. Most of the inflation we see in 2022 is a result of policy decisions from 2020/21 as there is a long lag to see the outcome of the initial policy decision.

Many forecasters may suffer from an availability bias and extrapolate the recent past such as interest rates and inflation will continue to rise indefinitely without considering debt levels and growth in credit and money.

But what if we looked closer at how money flows through the economy, would this give us some perspective on which potential assets may thrive more in a high consumer price inflation/below trend monetary inflation paradigm such as the U.S. dollar trade-weighted index?

So rather than using the current inflation reports and extrapolating the past into the future, should we try to determine the cause/effect relationships and potential lead/lags between money/credit growth and price changes across consumer goods and assets?

This is why Global Liquidity trend (with a 6-mth lead) are incorporated into our investment process through the Global Risk Indicator to signal whether we should invest in the Risk-on portfolios or Risk-off/Safety portfolio.

Current consensus estimates for the S&P 500 Operating Earnings per Share are $239 for 2023. This appears at odds with declining liquidity growth over the past 9-mths and we expect this trend to continue as rate hikes are expected to continue as consumer price remains elevated. As a result, it does not appear that the market has discounted an earnings recession yet, which may mean more downside from where we are today, given that we have yet to see the outcome of the tighter money from 2022 into 2023 to 2025. There are many indications of slower growth ahead, but central banks do not want to repeat the stop-and-go policies of the 1970s and ensure that the inflation dragon is slayed and are expected to stay the course. However, given that debt-to-income levels are far greater now then in the 1970s, financial stability may come to the forefront as the most important concern and rate hiking abandoned.

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