What’s Been the Big Unseen Tailwind for US Markets?
Despite global economic tensions and geopolitical risks, financial markets have been booming. What’s really driving this? For a Quant’s perspective, we spoke to Solomon Tadesse, Societe Generale’s Head of North American Quant Equity Research.
Can you explain the sustained exuberance for buying US stocks despite all the apparent headwinds?
There are a few factors, but the two primary ones are expectations for monetary easing by the Fed and investor excitement around emerging sectors such as artificial intelligence.
However, another important tailwind for US markets currently that doesn’t get as much attention is the ample funding liquidity that was injected into the market by many central banks during the COVID-19 pandemic to alleviate the economic impact of the global shut-down. This liquidity has not decreased significantly since the pandemic, as reflected in the peak level of bank reserves currently in the system.
The positive impact that this funding liquidity is having on US markets is evident in the almost lockstep growth seen between bank reserves and the S&P 500 since the 2008 financial crisis and certainly since the pandemic (103% and 115% respectively).
How are you gauging the state of funding liquidity in the market?
Funding liquidity is traditionally assessed by the ease and availability of credit through the traditional banking sector. However, a large part of credit intermediation has become dominated by non-bank entities including broker-dealers operating beyond the realm of the traditional banking sector – a system referred to as ‘shadow banking.’
As a result, the balance sheets of these credit intermediaries can provide valuable insights into the underlying liquidity conditions in the system and are therefore useful for assessing the potential direction of asset prices.
During healthy financial times when liquidity and credit conditions are easy, intermediary balance sheets will often expand due to improved valuations of existing assets and robust new credit creation. In difficult financial times when liquidity is tight, balance sheets often shrink due to a deterioration in credit extension and dwindling asset valuations. As such, asset returns typically appear to correlate with intermediary balance sheet strength.
With the current economic uncertainty surrounding monetary easing and geopolitical tensions, it will be important to keep a close eye on intermediary balance sheets as a better gauge for the state of funding liquidity in the market and the overall strength of the economy.
Nothing can last forever. Where do you see storm clouds forming most ominously for US markets?
Rising geopolitical risks in Europe and the Middle East and increasing global economic tensions between the US and China are two key things to watch. Sticky inflation and higher-for-longer yields are also possible market impediments that could turn the tides.
But despite the presence of these risks looming around us, financial markets continue to hold strong. Interestingly, the most recent uplift in markets comes against the backdrop of quantitative tightening policies that are intended to drain excess liquidity from the system. As I mentioned, we have not seen a negative impact on bank reserves in recent years, instead observing increasing liquidity since the start of quantitative tightening policies. Thus, liquidity being at peak both in the traditional banking sector and the shadow-banking system from their balance sheet expansion provides a warning sign for risky assets going forward.