Is All The Cash In The Markets About To Flushed away?

The markets have been brimming with cash in the last couple of years, but there’s a risk that central banks are about to pull the plug on all that liquidity.

🕰 Recap

• It emerged earlier this month that the Fed will raise interest rates and start selling off some of its bond holdings much sooner than expected
• That’ll lead to a drop in liquidity that could, according to one investment firm, spell disaster for the prices of financial assets
• But real assets – which are a lot more attractively priced than financial assets – could be much more appealing in this market environment

✍️ Connecting The Dots

Most investors subscribe to the idea that stock prices are ultimately driven by a company’s underlying profit. But there’s an alternative view put forward by investment firm CrossBorder Capital that says liquidity – the amount of money in the global financial system available for investors to access – matters more. That’s because it has a major impact on investors’ ability to purchase financial assets like stocks and bonds.

But here’s the thing: liquidity is heavily influenced by central bank actions. When they cut interest rates or purchase bonds, they’re essentially flooding the global financial system with cash. That, in turn, lifts up the prices of all financial assets – everything from stocks to cryptocurrencies. So it’s easy to see why markets have had such a remarkable run since the spring of 2020, when the world’s central banks embarked on an unprecedented amount of monetary support.

But central banks are now starting to withdraw that support in an effort to combat sky-high inflation. The Bank of England already raised interest rates last month, and new details from the US Federal Reserve’s meeting in December suggest it’ll start raising interest rates as early as March – not to mention sell off some of the near-$9 trillion worth of bonds it’s accumulated on its balance sheet. All these actions will have the effect of siphoning off liquidity from the global financial system, which could give the prices of financial assets a nasty knock.

🥡 Takeaways

1. Some corners of the market are more at risk than others.

The assets most at risk are expensive-looking growth stocks – which are vulnerable to rising interest rates – and cryptocurrencies. The latter benefit when liquidity is flush and bonds barely generate any yield, since investors seek out riskier corners of the financial market to squeeze out any meaningful return. But when liquidity is falling, these assets are the first to plunge. Case in point: bitcoin has collapsed by more than 40% from the all-time high it hit around two months ago. As for growth stocks, the Nasdaq stock market index – which is heavily concentrated in techy growth stocks – is down by more than 10% from its peak, sending it into official “correction” territory this week.

2. Real assets could offer a good place to hide.

Jeremy Grantham of Boston-based fund manager GMO – a hugely respected presence in the investing world – reckons this is just the start, and that stocks are ultimately headed for a 50% drop. His recommendations? Buy into real assets like commodities, natural resources, and real estate – all of which offer inflation protection and look a lot cheaper than financial assets right now. He also suggests keeping some cash spare, so you can load up on financial assets when valuations drop to more reasonable levels again.

🎯 Also On Our Radar

Russia’s central bank proposed a complete ban on crypto mining and trading this week – a bold move considering the country is one of the world’s biggest centers for mining digital tokens. The central bank claims the plan is designed to protect the country’s financial stability and citizens’ wellbeing, but there could be another motive: it’s planning to introduce its own digital currency in the near future. As for the miners themselves, many speculate they’ll just migrate elsewhere if Russia goes ahead with the ban – similar to what’s happened in the past when China’s put its foot down.