Q4'24: Drinking the Kool-Aid

By: Jack Schibli

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TLDR: – "too long; didn’t read." We recognize our posts can be lengthy and challenging to digest, so here’s our executive summary:

Global asset markets are a function of the size of the global liquidity pool and the percentage allocation of this liquidity to assets.
Surging global debt loads have helped to expand the global liquidity pool nearly fivefold since the turn of the century, turning capital markets into refinancing mechanisms rather than providers of new capital investment.
The cyclicality of this refinancing creates a drag on global liquidity, which is likely to pressure risk assets in late 2025 and 2026 unless governments soften the blow in advance with new liquidity injections.
Despite the narrative of tight monetary policy, the combination of stealth Federal Reserve and U.S. Treasury actions created significant liquidity injections in 2023 and 2024, driving asset prices higher.
The modern economy is now a reflection of asset prices, rather than vice versa, via the wealth effect transmission mechanism.
The Trump administration, specifically incoming Treasury Secretary Scott Bessent, will be forced to a crossroads - continue accommodative liquidity provisions or risk a deterioration of asset prices and, subsequently, the economy.

The Liquidity Framework 🌊

In this post, we will draw heavily on concepts from the writings of Michael Howell, author of Capital Wars (2019) – full credit to him, and we recommend following his work here. He diligently models global liquidity to forecast global markets, underpinned by the simple idea that asset prices are a function of 1) a global pool of liquidity and 2) the allocation of this liquidity to assets. Liquidity is an abstract term, but Howell defines it not simply as the total amount of money in circulation (ex. M1 or M2) but instead as the availability of funding and credit within the global financial economy, as it is the balance sheet capacity of the financial economy that can create or destroy liquidity.

Howell describes how the allocation of liquidity to assets is influenced by “(1) demographics, i.e., younger age cohorts favor equities over bonds; (2) inflation, i.e., real assets perform better in high inflation and bonds do best in deflations; (3) taxation, i.e., taxes may encourage or discourage savings, and (4) risk appetite, i.e., more risk-seeking investors are likely to favor equities over bonds”. Interestingly, over the last few decades, the allocation of liquidity to equity assets has remained relatively rangebound, far from the speculative excesses seen in the dot com bubble at the turn of the century and the housing bubble in 2006/2007, though it is approaching a fifteen-year high.

For Illustrative Purposes Only

This implies that the driving factor of equity returns in recent years has primarily been a significant expansion in the global liquidity pool rather than any major increase in the allocation of liquidity. The global liquidity pool comprises central bank activities, bank and shadow bank credit, corporate cash flow, collateral-based wholesale and repo market activity, and net foreign flows. Howell estimates this to be ~$175 trillion, up nearly five-fold since the turn of the century.

The expansion of global liquidity is heavily correlated to the expansion of global debt. The catalyst for the acceleration of Western sovereign debt loads, and thus monetary creation, was in large part thanks to the rise of China. The fall of the Berlin Wall in 1989 and the subsequent dissolution of the Soviet Union initiated a new era of liberalized trade and increasingly globalist policies, headlined by China’s acceptance to the World Trade Organization in 2001. Specifically, China became the world’s factory as Western nations exported their manufacturing sector, leaving behind languishing domestic economic growth. China, which began to run massive trade surpluses, accordingly accumulated significant foreign exchange reserves, while the West ran increasingly large deficits. This imbalance created a structural change in the global monetary system, as China’s reserves became the primary financing source for Western governments, who leaned on debt to bolster domestic economic growth.

The Institute of International Finance reports global debt surged to a new record of $323 trillion at the end of the third quarter of 2024. Michael Howell estimates the average maturity of this debt to be roughly five years, meaning every year, some $64 trillion must be refinanced – however, the distribution of maturities is not linear. To put this in perspective, world GDP is approximately $115 trillion, meaning 55% of GDP is needed to roll existing debt. This reality flies in the face of economic textbooks, which proclaim the role of capital markets is to fund new investment, but the modern role appears to be a debt refinancing mechanism now four times larger than new capital investment (that’s $4 out of every $5 in financing activity!).

For Illustrative Purpose Only

As noted, the maturity schedule of global debt is not evenly distributed, and therefore, global liquidity is cyclical. Howell empirically finds this cycle to be ~65 months, or a little over five years, which is perhaps quite sensible given the average maturity of world debt roughly matches this timeframe. His analysis below suggests an estimated peak in liquidity in the second half of 2025, followed by the onset of a down cycle. This is the maturity wall of 2025/2026 in action – a risk we discussed in our 2023 post – The Great Re-Financing.

For Illustrative Purposes Only

Refinancing is a relatively straightforward and unavoidable mathematical reality. We highlight that debt being rolled in the coming years will be refinanced at much higher interest rates than the debt it is replacing. If not already clear, this refinancing activity will require liquidity – or balance sheet capacity – and thus, funds must flow out of risk assets to fund this new debt UNLESS the government resorts to printing the difference. If history is any guide, governments will ultimately step in to fill the void, but usually not without initial discomfort for risk assets.

In our view, the world has evolved from a period of monetary dominance, where central banks were more or less in control of economies, using monetary policy as their toggle, to a world of fiscal dominance, where governments are in charge of economies, and the central banks are the enablers of their spending. In past cycles, central bankers have been able to use higher interest rates to slow the economy, sometimes into recession, and by doing so, find buyers for government debt via a flight to safety. Unfortunately, the past few years have proven this method outdated. Rising interest rates with this high level of debt not only provided the economy with significant stimulus but also had the government digging its grave even deeper by blowing out the deficit due to rising interest expense.

The liquidity framework appears to provide an answer to why the fervently called-for U.S. recession by so many economists and forecasters (guilty as charged) never materialized. The size of the financial economy (liquidity pool) now dwarfs the real economy; therefore, the outcome of the real economy is largely determined by liquidity with the wealth effect as the transmission mechanism. Liquidity ⬆️ = Risk Assets ⬆️ = Wealth ⬆️ = Economy ⬆️ . This also sheds light on why the Federal Reserve so often ignores inflation in the real economy (ex. “transitory” nonsense circa 2021, cutting rates prematurely circa 2024) because they are optimizing for financial markets rather than the real economy. It turns out that under the veil of higher interest rates and a restrictive policy stance, stealth actions by both the Federal Reserve and the U.S. Treasury drove a significant resurgence in liquidity, bolstering risk assets to new highs and consequently steering the economy away from recession.

First, the Federal Reserve, which on the surface claimed to be reducing its balance sheet via Quantitative Tightening (QT), was actually injecting liquidity from early 2023 onward. While the overall level of the Fed balance sheet was declining, only a subsegment of the balance sheet creates liquidity. Howell’s calculation for Fed’s Net Liquidity = Fed Balance Sheet – Treasury General Account – Reverse Repo – Fed Net Operating Losses. As shown in the chart below, Fed Net Liquidity appears to have flat-lined after the UK Gilt Crisis in late 2022, then re-accelerated after the Fed stepped in to cover for the regional bank crisis of March 2023 with the Bank Term Funding Program (BTFP) facility.

For Illustrative Purposes Only

Secondly, and more impactfully, Janet Yellen at the U.S. Treasury similarly provided material liquidity support under the radar. Tasked with funding the U.S. Government’s spending habit, Yellen drastically pivoted her Treasury issuance to T-Bills (short-term bonds). By issuing a higher share of bills instead of coupons (long-term bonds), Yellen artificially decreased the supply of available coupons, thereby reducing the interest rates on long-term bonds. According to a seminal paper by Nouriel Roubini and Stephen Miran of Hudson Bay Capital, this so-called “Activist Treasury Issuance” (ATI) was equivalent to a whole one percentage point cut in the Federal Funds rate, as Yellen shifted bill issuance from the historical 15-20% target to a high of 80%^[1].

For Illustrative Purposes Only

In fact, according to Howell’s work on this same phenomenon, without Yellen’s shadow yield curve control (YCC), the Treasury curve would have never inverted, which is coincidentally one of the leading (and undefeated) indicators of U.S. recession that many forecasters pointed towards to strengthen their recession case. After adjusting for what Howell calls “Not QE, QE” (Federal Reserve) and “Not YCC, YCC” (Treasury), he finds that liquidity expanded significantly in 2023/2024, amounting to nearly $6 trillion or 15% of total U.S. liquidity at its peak, rivaling the 2020/2021 pandemic liquidity injection^[2].

For Illustrative Purposes Only

In his 2010 Jackson Hole speech, then-Fed Chairman Ben Bernanke described how quantitative easing drives investment further out the risk curve, supporting risk assets in what he deemed the “portfolio rebalance channel.” Unsurprisingly, this hidden liquidity injection found its way into the U.S. stock market, likely a significant contributor to the strong returns of 2023 (+26%) and 2024 (+25%) in the S&P 500. Hopefully, it has become apparent, but liquidity is very strongly correlated to asset price returns, as evidenced below.

For Illustrative Purposes Only

2025 may bring significant changes to the liquidity environment. The shadow liquidity injections from the Fed and Treasury are already fading. We do not find the timing and magnitude of such liquidity immediately before a major presidential election nor its reversal in the wake of Trump’s victory coincidental. We see these as very calculated political moves. Incoming Treasury Secretary Scott Bessent, a former hedge fund manager, has been an outspoken critic of Janet Yellen’s Activist Treasury Issuance per his January 2024 letter to clients: “Over the short-term, this change in issuance strategy has had the desired effect, with financial conditions easing materially since the November 1 [2023 QRA] announcement. However, over a medium-term horizon, we believe this is a risky strategy, and it comes with significant costs. In addition to a higher interest expense, concentrating issuance in short tenors exposes the Treasury to greater volatility via refinancing risks and creates the potential for a financial accident”. Bessent's honoring of his word would likely mean a significant rise in long-term interest rates, as a flood of new long-duration issuance would need to be absorbed by the market, undoubtedly pressuring equities. However, Trump’s obsession with a strong stock market may prove a conflicting force behind closed doors. We would rate rising long-term interest rates the #1 threat to Trump’s pro-growth plans. Bessent will have his hands full - in an interview before his nomination, he likened balancing the deficit without causing a recession to a "mid-air refueling in a Cat 5 Hurricane."

Therefore, we are approaching 2025 with caution, particularly the second half of the year when refinancing needs are poised to rise significantly, negatively impacting liquidity conditions. U.S. equities at the index level certainly do not carry a substantial margin of safety. S&P 500 concentration has never been higher (since record-keeping began in 1980), with the top ten stocks amounting to 37% of the index and just 26 stocks accounting for half of its value – frightening if you ask us. Most of the world seems to own the same handful of stocks, and many don’t even realize it, masked by the black box of “passive” investing. The S&P 500 also carries a historically expensive forward price-to-earnings ratio in the 95th percentile, thanks to last year’s multiple expansion, as earnings growth accounted for less than half of the 2024 index return. Here’s a chart from Goldman showing the index is expensive regardless of which metric you pick.

For Illustrative Purposes Only

We did not spend much time on the allocation of liquidity aspect of the liquidity framework. If you return to the very first chart, you will note the allocation of liquidity is at a fifteen-year high. Based on a Tax Policy Center study from 2019, the top three participants in equity markets are 1) foreigners (40%), 2) retirement accounts (30%), and 3) taxable accounts (25%). The same study found that foreign ownership has doubled since the turn of the century. We believe this results from globalization and the U.S. running massive deficits – our deficit is someone else’s surplus. The U.S. net international investment position averaged 4% of GDP in the 1980s, but today – post-globalization – it stands at -80%. Foreigners have piled into U.S. assets. We suspect any efforts to reduce the deficit materially – the raison d’etre for Trump’s DOGE – will result in declining foreign equity investment flows. We also believe a weaker U.S. dollar policy – something that Scott Bessent has publicly favored – will push foreigners to sell U.S. dollar-denominated assets, further lowering their allocation to U.S. equities.

The next largest cohort – retirement accounts – are perhaps the stickiest owners of equities, with most employed Americans contributing to their retirement accounts with every paycheck, most popularly via a company-matched (3-6% of salary) 401(k) contribution. The long-term nature of these accounts, in addition to tax incentives, means investment flows of this cohort are most inelastic to changes in the real economy, provided employment remains stable – a key caveat. We believe that the employment level and wage growth – both strong as of late – are deterministic factors toward overall retirement contribution levels. Retirement allocations are also sensitive to demographics. Notably, the Baby Boomer population is charging into retirement, with more than 4.1 million Americans turning 65 annually from 2024 through 2027 – a new record. This “Silver Tsunami” is likely to rebalance towards fixed income allocations and perhaps be most reactive to equity market volatility, as they cannot afford significant drawdowns at their stage of life. A 2023 Vanguard study found that nearly half of Vanguard 401(k) investors managing their own money and over age 55 held over 70% of their portfolios in stocks, compared to just 38% in 2011.

The very first chart presented shows a relatively stable allocation of liquidity, but it is a global reading. When looking more closely at U.S. households, we find that equities as a percentage of total household assets are at all-time highs. Admittedly, this is partially a function of equities outperforming other assets in recent years, thus gaining a bigger share of the pie. This statistic supports the significant role of equities in household’s perception of their own wealth, which supports household spending and economic activity – the wealth effect at play. Perhaps more concerning, according to the conference board survey, a record share of U.S. households expects higher stock prices by next year.

For Illustrative Purposes Only

Our long-term views remain unchanged. One of the key takeaways from Howell’s liquidity framework is that “printing” money will be the government’s solution to every liquidity crisis, with each “fix” multiples larger than the last. Currency debasement remains one of our core themes in the decade ahead, and in our view, the best assets to hedge this trend are those with a finite supply, specifically gold and Bitcoin. Neither will be spared from a liquidity crunch but should outperform following what is now a predictable government response. We are cautious about the outlook for U.S. equity indices, as virtually the entire world seems to be in on the same trade of just fifty or so stocks – “when everyone is on one side of the boat, you should probably go to the other side.” The liquidity cycle has birthed the likes of "Fartcoin," a meaningless, AI-created cryptocurrency that, at its peak, had a market cap ($1.25 Billion) greater than 80% of publicly listed U.S. companies. Its tagline, rather fitting, describes the liquidity phenomenon effortlessly - "Hot Air Rises." Will the Trump administration ensure the Kool-Aid continues to flow in 2025?

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Sources:

Unless otherwise noted, all financial data is sourced from Refinitiv Data or Federal Reserve Economic Data (FRED).

^[1] Miran, Stephan and Roubini, Nouriel. ATI: Activist Treasury Issuance and the Tug-of-War Over Monetary Policy. Hudson Bay Capital. July 2024

^[2] Howell, Michael. Could Bond Vigilantes Hostage US Policy Makers? Capital Wars. January, 2025.