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Economic: Liquidity Unplugged
New York: June 12, 2006
By John R. Stephenson

"But what they perceive as newly abundant liquidity can readily disappear.This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

--Alan Greenspan (August 2005)

The markets have witnessed some ugly sell-offs over the last few months, which have left investors bruised and dazed. Commodities and the stocks of commodity producers are off sharply, as well as every other major stock market sector and most stock markets. In fact, two-thirds of the world's stock markets are down some 10 percent or more since the start of this sell-off. Emerging markets are down substantially and the NASDAQ is down by some 10 percent while the Dow is off some 6.4 percent. So, is it over?

Not yet. What we are witnessing is a great unwinding of some of the excess money supply (liquidity) in the system with the catalyst for change being a near simultaneous rising of interest rates by central banks around the world. When interest rates go up, the cost of borrowing money also goes up with the consequence being that investors start paying closer attention to the risks that they are taking. The riskier assets, such as commodities (which can be bought using tremendous leverage), emerging market stocks and junior mining as well as oil and gas companies suddenly don't seem like such a bargain. The result? Investors have been stampeding for the doors leaving stock prices reeling in their wake.

Figure 1: EEM - An Emerging Market ETF

Source: Yahoo Finance

Stock markets around the world have tumbled as liquidity (availability of money) has dried up sending investors scrambling for cover. The hardest hit markets have been smaller, emerging markets such as Saudi Arabia's exchange which is down 58.5 percent from its peak earlier this year. Russia's stock exchange is down 22.2 percent from earlier this year.

By raising interest rates in a coordinated manner, the world's central banks have caused liquidity to dry up and made it more expensive for large fund companies to borrow huge sums of money for investing. For the past several years, fund companies have enjoyed a favorable situation whereby they were able to borrow abroad (mainly from Japan) and invest domestically in commodities, junk bonds and emerging markets at little or no cost.

But with Japanese policy makers now worried about the specter of inflation (rising prices) rather than deflation (falling prices), the Bank of Japan has been sending their key-lending rate higher. With Japan providing much of the world's liquidity (easy money) and a strong signal from the Bank of Japan that it is planning on ending its zero interest rate policy, nervous fund managers are unwinding their bets on riskier asset classes.

Over the past thirty-five years, Japan has been the provider of choice for fund companies looking for a cheap source of money. During this time frame, Japan has allowed its monetary base to double rapidly (less than three years) on several occasions, which has, in turn, created bull markets in real estate, stocks and commodities around the globe. Today, Japan, like other major countries around the globe, is increasingly concerned about inflation (rising prices) and as a result is in the process of raising interest rates and shrinking the money supply rather than increasing the money supply as they have done in the past. The result? There is less money available for borrowers and the money that is available costs more to borrow.

Inflation is a constant worry for central bankers around the world. Rising prices can, in their most chronic stage, turn into a spiral where manufacturers and suppliers of all types are continually raising their selling prices for goods and services because they expect that the items that they buy will continue to be more expensive in the near future. So what exactly is the problem with chronic inflation? The only cure seems to be high levels of unemployment and a very deep recession.

For this reason, central bankers are extremely worried about inflationary pressures and take pre-emptive measures (raising interest rates) to ward off inflation before it becomes chronic. This is what is happening currently as central bankers around the globe have become concerned with the higher costs of energy and other goods and services and have decided to raise interest rates to reduce the likelihood of chronic inflationary pressures developing.

But as interest rates rise higher and higher, government bonds and corporate bonds start to look more and more attractive to investors. Why would an investor put money into a stock which has business risk if the expected return from a stock is only seven percent and a government bond, which carries no investment risk, also pays seven percent. In short — the bond market competes directly with the stock market for capital and when bond yields (interest rates) are high, stocks are generally for sale.

With new financial players in the market who use massive amounts of leverage (borrowed money) to enhance their returns, the game has taken on new meaning. For many leverage players (such as hedge funds) borrowing money at 40 basis points (i.e. borrowing from Japan) and investing at an expected return of 10 or greater percent looked like a great deal. But with interest rates globally on the rise, this type of investment strategy is getting more expensive to implement and a whole lot riskier.

While all of this is bad news for hedge funds, proprietary trading desks and you and me, in the short term, it will ultimately be a good news story. The reason? Because by ringing some of the froth and momentum out of the market, investors will have an opportunity to buy some great quality companies at substantial discounts to the prices available just a few short months ago.

Energy and base metal stocks which have been beaten up lately will rally again as demand is still strong and production continues to struggle making this a sector that will continue to outperform.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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