Reply #39: Year in Review: Reflation to Gross Over-Liquefication

[54anickel]

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I haven’t read anything from the general or business media that does 2004 justice. Most articles mundanely note that equity returns lagged 2003, while bonds posted surprisingly good if not stellar returns. Yet focus on the major equity averages and the Treasury market misses the major story of the year: rampant liquidity excess and rising inflation. For the year, The Street.com Internet index was up 36%. The Dow Jones Transports jumped 26.3%, and the Dow Jones Utilities gained 25.5%. The Morgan Stanley Cyclical index rose 15.4%, and the NASDAQ Industrial index gained 15.8%. The small cap Russell 2000 surged 17%, and the S&P400 Mid Cap index jumped 15%. The Securities Broker/Dealers jumped 15%. The NASDAQ Insurance index jumped 19.8%, and the NASDAQ Other Financial index rose 19.6%. The NYSE Energy index gained 25.5%. The AMEX Composite rose 22.2%. The AMEX Biotechnology index gained 11%. The NASDAQ100 gained 10.5%. The S&P 500 Homebuilding index posted a 2004 gain of 33%. Clearly, sectors and groups that one would expect to be the most sensitive to over-liquidity and inflation have, in most cases, performed exceptionally well.

I realize some analysts continue to note the less than overwhelming 6.6% 12-month expansion in M3. I would like to again emphasize that “money” supply may not always be indicative of system liquidity. Today it is not; liquidity conditions remain overwhelming.

First of all, it is worth noting that M3 less money market fund assets expanded at a 10.3% rate over the past year. Many have had good reason to use bank and money market deposits to purchase some of the inflating quantity of higher-yielding Treasury bills and notes. Generally, there continues a major flight into riskier and higher yielding securities, which fueled record sales of junk bonds, huge record issuance of ABS, and strong issuance of CDOs and other structured products. Also, total Commercial Paper outstanding expanded by 11.5% this year. And with two weeks of data yet to report, we are about to conclude a record year for bank Credit growth (up $543bn, or 8.6% ann.). Bank loans have expanded at a 10.6% rate, with Real Estate loans increasing at a 14.4% rate. Even C&I (commercial & Industrial) loans will post a small rise (approx. 1.6%) this year, the first gain since 2000. Moreover, second-half C&I growth increased to a 6.2% rate. And, according to the Fed’s “flow of funds” data, Broker/Dealer assets expanded at a 12.6% rate during the first three quarters of the year. And, importantly, 2004 will most likely post another record year of $1 Trillion-plus total mortgage Credit growth.

Any discussion of systemic liquidity must also note the ballooning (largely with dollar securities) of Asian central bank balance sheets. The latest data from Bloomberg has Total Asian (Japan, China, Taiwan, Korea, Hong Kong, India, and Singapore) central bank foreign reserve assets up almost $460 billion over the past 12 months (28%) to $2.1 Trillion. (As noted above, foreign “custody” holdings of U.S. securities held at the NY Fed are up 25% this year to almost $1.34 Trillion.) I would argue that liquidity has never been as abundant and that U.S. monetary aggregate growth has been impinged by the nature of current dollar balance “recycling.” Instead of foreign exporters holding U.S. liabilities that would in many cases be included in M3, foreign central banks are acquiring these balances and recycling them into U.S. Treasuries, agencies, and other securities/instruments that are not components of “money” supply.

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To wrap this up this brief and incomplete “review,” we are now 25 months into historic “reliquefication.” As students of inflation would expect, the nature of Inflationary Manifestations has evolved and intensified over time. I would strongly argue that the powerful strain of inflation that has taken hold during 2004 is of the most precarious variety. “Animal spirits” and speculative impulses have been unleashed everywhere. And the problem with extended periods of rampant over-liquidity is that it becomes only more difficult to wean the levitated financial markets, inflated asset markets, and distorted economy off the stimulant. I expect that The Year it Didn’t Matter will be followed by The Year it Does.

Love that last line :smoke: