The financial landscape is changing, and investors are being advised to approach the stock markets with caution due to potential market corrections. These corrections have historically been accompanied by increases in long-term interest rates, but the timing of market reactions is unpredictable.
Currently, the US money supply, specifically the M2 aggregate, is increasing, which may delay any immediate market responses. However, a significant decline in this indicator could be a sell signal for investors, prompting a reassessment of portfolio risks.
The yen carry trade is also a factor to consider, as a significant weakening of the dollar against the Japanese yen could indicate an unwinding of this trade. This would likely lead to capital outflows from the US, reducing liquidity both domestically and globally. Investors should be vigilant for these signals in the coming months, as they could require a strategic reduction in portfolio risks.
Contrary to popular belief, stock market performance is not directly tied to economic conditions. Stock markets often lead economic trends, so it is important to focus on liquidity rather than solely on economic indicators. The current strong state of the US economy does not guarantee continued growth in stock and credit markets. Instead, a recession may only occur after a significant downturn in these markets.
The recent election of Donald Trump as President of the United States has not changed this dynamic. His proposed business-friendly measures are expected to impact the economy, inflation, and long-term interest rates, but they are unlikely to have an immediate effect on stock market performance. The flow of money and liquidity, driven by central banks and private banking systems, plays a more decisive role in shaping market trends.
Various leading liquidity indicators have been weakening, raising concerns among market analysts. The US Federal Reserve's Overnight Reverse Repo Facility, a significant source of liquidity, has been drying up. Approximately $2,500 billion in excess reserves have been drawn down over the past 18 months, contributing to the performance of equity and credit markets. However, with these reserves nearly exhausted and the Fed's quantitative tightening continuing, there is a potential for a monetary vacuum.
The implications of declining liquidity are often felt with a delay, suggesting that while the market has not yet reached a critical point, it is approaching a monetary danger zone. Despite the current residual liquidity in the system, ongoing high levels of government spending in the US are partially offsetting the declining liquidity supply.
Fundamental economic imbalances in the US are becoming more pronounced. The service sector is currently the primary driver of economic activity, while the manufacturing sector and small to medium-sized enterprises (SMEs) face mounting pressures. This unsustainable economic structure, coupled with a weakening labor market, raises concerns about the long-term stability of the economy and its impact on stock markets.
Current market sentiment appears to be overly optimistic, with significant share sales by major investors becoming noticeable. This trend is occurring even as valuations approach historic highs, raising questions about the sustainability of the current market rally. The consensus among investors is that the measures proposed by the new administration will bolster equity markets, leading to a disregard for potential underlying problems.
Investors must remain vigilant and adaptable, keeping a close eye on liquidity trends and economic indicators. The interplay between government policies, market sentiment, and fundamental economic conditions will ultimately shape the trajectory of the stock markets in the months to come.