On liquidity

The Short View: On liquidity

By John Authers, Investment Editor | 3 November 2007

Liquidity has oiled the wheels of global markets for years. The sudden gush of it created when the US Federal Reserve cut its discount rate in mid-August has also propelled the ongoing rally in many emerging markets.

But liquidity is not an exogenous concept. Excess cash is created when companies make bigger profits. Signs of slowing economic activity signal that the spigot of liquidity may soon be turned off. It is also a fluid concept. Beyond flows of cash from investors, it includes money tied to the credit market.

Company buy-backs of their own stock and corporate takeovers funded by cash or debt both have the effect of cutting equity in circulation, pushing up share prices. Buy-backs hit record highs early this year while credit spreads were at record lows. This was no coincidence.

Developed-world stocks seem only now to be feeling the knock-on effects of the credit crisis for buy-backs and cash takeovers. TrimTabs, a research group that monitors US liquidity, this week turned negative on the US stock market for the first time since April. It did this after three cash takeovers, worth $39.6bn, were cancelled this month. As for buy-backs, they are often announced at the same time as corporate earnings. They are running at about 37 per cent below their level for the last earnings season, and TrimTabs is cutting back its estimates for new buy-backs. More companies are issuing stock, although new issues remain modest.

In London, cash takeovers on the London Stock Exchange are far below their levels of a year ago, or of the period earlier this year when credit was cheapest.

There are reasons to be optimistic. US retail investors are not now putting money into their domestic market. Should they do so, that would be positive. But it does appear that the flow of liquidity is slowing and that this should temper optimism about developed-world stocks.

Normxxx    
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