In a recent note, Matthew Hombach, Chief Rates Strategist of Morgan Stanley, wrote that Central Banks will inject another $2.8trn of liquidity in the global financial system in 2021. This would be the double the amount of highest liquidity injection in any year prior to 2020. This abundant liquidity, in Matthew’s view, will support the riskier investments at the expense of investments entailing lesser risk; implying weaker USD and US Treasuries and Stronger EM currencies and Equities. The caveat however is “if central banks signal a reduction in liquidity earlier than we expect, or our economists’ buoyant expectations aren’t met, risky assets could experience a wobble, a theme that might very well feature in our 2021 mid-year outlook”.
The conventional theory is that as the supply of transactional
currency (money) rises, the price of money (interest rate) decreases. The lower
interest rate results in lower cost of owning and carrying assets resulting in
higher demand, and therefore higher price, for assets. Lower cost of money is
also traditionally believed to increase the risk taking ability of the
borrowers, resulting in higher demand for riskier assets, e.g., equities (over
debt), emerging market assets (over developed market assets) etc. Lower cost of
money is also seen to be catalyzing the flow of savings (surplus liquidity)
from low yielding assets (e.g., USD, JPY, developed countries’ bonds etc.) to
high yielding assets (e.g., emerging market currencies & bonds).
Also, as per conventional theory, the rise in supply of money
which is not matched by rise in production of goods and services, inevitably
results in rise in prices of goods and services (inflation).
However, the market trend seems to have strongly defied these
conventional theories in past 10 years. Ever since the global central banks
adopted the new normal monetary policies of abundant liquidity and near zero to
negative interest rates, the demand and prices for developed market assets
(USD, Developed market bonds and equities etc) have mostly outperformed the
emerging markets and the prices of physical commodities have remained low,
notwithstanding the small bump in recent months.
I think, the investment strategy needs to assimilate the trends
in monetary policy, asset prices and inflation (of goods and services) in a
holistic manner rather than drawing conclusion from the bits and pieces. The
economic and financial research may better focus on the issue whether—
(a) The excess (or
additional) money printed in since the internet revolution started in late
1990s is to adjust the stock of money for rise in productivity,
dematerialization, colossal rise in income and wealth inequalities and
consequent changes in consumption, trading and investment patterns, changes in
velocity of money etc.; or
(b) The conventional
theories are still valid and we are just protracting the inevitable, i.e.,
hyperinflation in prices of goods and service
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