Benign liquidity conditions failed to prevent a sell-off in stocks last quarter as risk appetite deteriorated in response to ongoing credit market deterioration and an associated downward revision to expectations for economic activity and earnings.
The interplay of liquidity and risk appetite is illustrated by the chart below, showing “excess” money growth in the Group of Seven (G7) economies (i.e. the gap between annual expansion rates of the real broad money supply and industrial output) and a measure of risk aversion based on the VIX options volatility index. Stocks tend to perform well when excess money growth is positive and the risk measure is close to or below zero. Sharp rises in risk aversion neutralise or outweigh the impact of positive liquidity – in effect, the velocity of money falls and liquidity is temporarily “frozen”. Historically, however, periods of intense risk aversion rarely last more than about six months. The current episode is mature and recent additional official actions to stabilise credit markets may lead to a revival in risk appetite over the rest of 2008, allowing stocks to rally.
This assessment is subject to two caveats. First, the G7 excess money measure is biased upwards currently by “reintermediation”, i.e. the rerouting of financial flows through the banking system due to the collapse of off-balance sheet vehicles. One way of adjusting for this effect is to expand the monetary definition to include commercial paper used to finance such vehicles. This suggests “true” G7 excess money expansion of 4-5% rather than 6-7% – still significantly positive.
Secondly, while investor fear levels should abate, a return to risk-loving behaviour in equity markets is unlikely against the backdrop of slowing global economic activity and likely further downgrades to earnings estimates.
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