Will We See Equities Without Liquidity Flows?

The global equity markets have been in a very strong uptrend, since March, in a rally that drove the major indexes up approximately 50%, as most are quite well aware, with the foundation behind the rally being the ample liquidity programs ran by the world’s central banks.

The state of the global economy, and the outlook for growth at any cost, has changed since the first quarter of quantitative easing adrenaline fixes hit the markets. In March, the end of the financial system was very close according to some, with the established markets standing on the edge of an abyss, we are told.

Right now, the U.S. economy is expanding, while the financial system appears to have stabilized, with of course the U.K.’s RBS and Lloyds being excluded after recent revelations that they are still absorbing quantum sized losses and need the drip-fed liquidity of the U.K. Government and central bank.

For most market participants, a stable financial system together with an expanding economy is a clear signal that most established economies central banks will abandon the ultra-low interest rates that had lured investors into virtually all assets classes over the last year or so. It means that central banks will try to exit from the quantitative easing programs sooner rather than later, and that will be done, by default, with an increase in interest rates.

The equity and commodity rally started with liquidity flushing into the financial arteries, but now, the market shows sign of bearishness as this excessive liquidity is slowly draining out of the market. This might be a good explanation for the selling seen in the financial sector, and the XLF market, over the last two weeks of trade, as investors weigh the impact of central banks signaling that they are preparing to hike their key overnight rates during the coming quarters.

The timing is quite interesting, since on Wednesday and Thursday the markets await the monetary policy decisions from the Federal Reserve, the Bank of England, and the European Central Bank, that will add to the 50 basis point move over the last month from the Reserve Bank of Australia, with 0.25% being tagged on at last Tuesday’s meeting.

It has been noted that Fed officials have removed the phrase that interest rates will remain low for extended periods in their recent speeches. The Fed, as any other central bank, uses speeches and jawboning to anchor market’s expectations, so this is another sign for investors that the Fed might preparing market participants for more tough talk on the impact of low interest rates for extended periods of time.

The previous moves by the Fed from these levels lead to a 0.25% increase in rates every month for over a year and a half, that may have been too long a period to string out an increase of that size. The opinion is that a more aggressive move may have tempered the subsequent ability of the market to start the over-leverage debacle that generated such mass hysteria as sub-prime and then the credit-crisis hit home.

With this being said, it will be interesting to observe how the financial markets will react if the Fed, BoE and ECB, do provide a bullish outlook for their individual economies, and therefore for global growth. The question is now, whether the equity rally can continue the uptrend, without cheap money floating around that has the ability to not only float, but also then hold higher, most asset classes.

It is unlikely that Q3 earnings numbers are strong enough to sustain such relatively lofty valuations that were created in the March-October 09 period, and therefore the swing-point fundamentally may come from the bankers taking away the liquidity punch-bowl.

Disclosure: No positions