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The forgotten war

 Salomons Judgement

While ‘trade war’ is a trending topic these days, an almost forgotten war rages in the background: the battle for liquidity.

The media often talk about trade wars. Every downturn in markets is said to be caused by escalating trade tensions in the world. Don’t get me wrong, this is a serious problem. But due to the focus on trading relationships, investors risk overlooking another war. Listen carefully … Do you hear the sucking sound of the liquidity drain? Now that the war on deflation is won, the Federal Reserve (Fed) is withdrawing money from the system and not without consequences.

Driven by the power of the American economy, the world economy is growing slightly less than in 2017, but still more than average. The heyday is back. The - belated - fiscal stimulus led economists to revise upwards their estimates for the American economy. Inflation is picking up slowly and the Fed wants to raise interest rates by a quarter per quarter. There is no reason to keep interest rates extremely low, and the bank’s balance sheet could also be a lot smaller. After all, the economy is doing well.

Why should investors still be concerned? To clarify these concerns, we dive deeper into the world of money and credit data. Credit growth through American banks (Commercial & Industrial Loans) has increased to 5.4% in June. An acceleration from 1% earlier this year. In stark contrast money growth (M2) keeps declining. It has dropped to just 4.2% in June. The combination is good news for the US economy, but not for global markets. 

For a long time, money being created did not end up in the real economy. I mean that part of the economy where companies build factories and hire people... Instead, money was stuck in the financial economy, pulling down interest rates and fueling speculation in financial assets. As companies increasingly rely on banks, less money is available for the financial economy. This implies a risk for those parts of the market that have significantly benefited from free money. It’s not a coincidence that spreads on corporate bonds are rising, and emerging market debt is under pressure. A nice consultant study shows that these are the places with most debt expansion.

The Fed makes policy focused on the American economy. And that economy is booming. Don’t expect the central bank to stop raising interest rates soon. The concerns lie more outside of the United States as global growth is no longer synchronized. Not all engines are firing on all cylinders. The Fed’s increase in interest rates doesn’t negatively affect its own economy; it puts pressure on the weaker countries and exposes areas where free money has led to overvaluation.

Now that the ECB, in response to the Fed, has announced that it will stop its quantitative easing, corporate bonds in Europe are also a weak spot. The other one is emerging countries, yet again.

The author

Roelof Salomons

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