The Data Paints a Picture
and that picture is surprisingly clear
The M2 money supply data came out yesterday and no surprise we saw a negative YoY change for a third month in a row. This is something we’re tracking now. And by we, I mean the whole world simply because it seems to suggest that the Fed’s QT is working.
But, what’s even more alarming is that the change in money supply has never gone negative. Not even in Volcker’s time and there was some active policies in play to control M2 at the time. The chart below is from the 1960s to date.
But, zoom out a little and you see the total M2 money supply is still the highest in history and all this liquidity will take some time to be vacuumed out of the system.
But, don’t let that mislead you. The rate of change is important and it signifies that there is definitely a liquidity crisis in the making.
Now, what happens when money supply decreases? Well, depending on the velocity of money, the GDP decreases. We have a lovely equation in economics:
MV = PQ
While seemingly complicated, it is not.
M = the amount of money in circulation
V is the velocity of money (the rate at which money is spent)
P is the price level of goods
Q is the quantity of goods sold
So when money supply declines, it more often that not leads to a decline in GDP, because another name for GDP is PQ.
So we know the M, we know the PQ, now what about the V or the Velocity?
Well, if you look at the measure from a website, it’s basically a number derived from M2 and nominal GDP. But, one way to measure the velocity is to understand how much people are willing to borrow and lend.
How much are people willing to borrow and lend?
Quite a lot actually. What we’re seeing now is a gradual increase in debt levels. It may seem benign but, the levels are rising and rising at the worst end of the lending spectrum - credit cards and revolving debt.
We’ve been discussing the consumer as being weak for a while but, there are a great many out there who seem to refute it. Be that as it may, I think the data adds up. And if you follow the “rate of change” you will notice that we’re not exactly in Neverland any more.
Doesn’t seem like much? Let’s look take a step back and zoom out a little:
While we’re seeing credit card debt balloon, we’re also in an environment where the cost of borrowing has increased rapidly.
When you consider how interest rates are rising, the overall picture certainly remains bleak. The increase in the level of interest rates will mean a larger portion of people’s disposable income will start to go towards repaying debt.
We’re already seeing this with auto loans where over 15% of new car payments are now over $1000.
And finally, a chart I posted on Twitter earlier this week showing that the rate of change of debt is increasing compared to the rate of change of discretionary income. I got a few replies saying that in the grand scheme of things the proportion of payments as a percentage of disposable income is low. Note the terms: discretionary vs. disposable.
Firstly, discretionary income is narrower definition. It is the disposable income less necessary spending. So, what this chart suggests is that extra spending money is declining and secondly, the rate of change of matters, again!
But, with financial conditions tightening, and yes they have tightened since last year, we have a situation where banks can see the defaults coming from a mile away. Every bank that reported earnings this quarter showed much higher levels of provisions, or default reserves. And rightfully so, the level of distressed debt is definitely rising.
Add to that the recent Senior Loan Officers’ survey from the Fed that shows that banks are definitely tightening lending standards. As you can see below, this happens to be most pronounced during a recession and we’re close to reaching those levels.
The truth is the consumer is spending on credit cards and dipping into savings to meet the burden of higher expenses because of inflation. With interest rates rising, we have a situation where the debt burden will progressively become just that, a burden!
Add to that banks are not willing to lend freely anymore either. With the money supply declining, there is also the concern whether there will be enough liquidity to meet the debt burden.
So what we have is situation where people will be less willing to borrow or lend = the velocity of money is declining.
So we have money supply declining and the velocity of money declining = lower GDP.
The macro is quite clear… we’re headed towards a much tighter environment and a significant slowdown.
Right, so I’ve painted you a not-so-pretty macro picture. It’s time to come down to the real question:
Why did the market rally since the beginning of January and does this mean we’re in a new bull market?
Let me answer the second question first, no we are not in a new bull market!
But, there are several reasons that the market rallied in January and the first half of February - Liquidity!
The upside move was exaggerated by short covering rallies and same-day expiring options (0DTEs) but, the basic reason was still liquidity.
There’s a saying - when America sneezes, the world catches a cold. Well, these days the opposite seems to be true as well.
Sure, there’s some truth to the fact the Net Liquidity in the US increased, but, more importantly, it was liquidity from central banks around the world that gave the markets a significant boost, including Europe!
If you look at the chart below, you can see the significant uptick in the numbers for Japan and China. While Japan was drunk on bond buying, China was cutting rates and pumping indirect stimulus into the market.
But, what do we look for? That’s right, the rate of change! Here we go:
But, things are starting to calm down again. While Japan did some more bond buying in February, there’s been a somewhat of a pull back in recent weeks and the global money supply is now looking weaker.
Finally, we had consumer spending increase in January as well. There were two very interesting reasons for this:
The Cost of Living Adjustment of 8.7% increase in the Social Security allowance came into play from Jan 1, 2023. Approximately, 70million Americans will receive this benefit in some form. However, this is also a good time to mention that SNAP payment will be decreased from April, once the Covid emergency program goes away.
Overall, outdoor spending also increased as can be seen in restaurant and hospitality spending. It was a warmer winter for the most part and people put that to good use. This is temporary.
Closing Thoughts
We had a bear market rally. It’s as simple as that. I take absolutely no pleasure in saying that we still remain in a bear market and we are yet to see another leg down to perhaps what might be the market bottom.
I’ve tried to explain why the overall macro picture is bearish and that’s perhaps helpful to understand so you have some context as to where we are headed. I have on confusion, and while there may a few shades of grey here, the picture is not at all fuzzy to me.
I’ve also tried to explain why we had a bear market rally. But, the truth is we don’t always need to know why we have such rallies in a bear market, what we need to accept is that they happen and while they happen, if you have positions going against you, then patience is a virtue.
Navigating a bear market is never easy. I can’t claim to be some kind of expert but, what I can tell you is that keeping positions small, stop losses tight and not using too much leverage can all help.
Really well organized and clear. Nice to see an even wider angle macro lens from you both. 🥋
Great article, short, sweet and to the point