Monthly Commentary Howard Wang of Convoy Investments
Tightening money supply
This year has been a process of normalization in financial conditions. Below I show the estimated money supply in the US, which rose fairly steadily before we saw a spike in 2008. That spike lasted until the end of 2014, after which the Fed began to withdraw money from the system. US money supply shrank for the first time in almost a century.
This chart has been the fundamental driver of asset prices over the last decade and will likely continue to drive the markets until the Fed normalizes their monetary policy. On average, more money chasing the same assets means higher prices while less money means lower prices. Below I show the relationship of growth in the US money supply to the long-term return of assets.
The falling money supply since 2014 is driven by a combination of rising rates and direct unwinding of quantitative easing. Below I show the duration adjusted Fed balance sheet. I believe the trend of shrinking money supply in the system will continue for some time to come. This adjustment is a painful but necessary process for healthier markets and economies.
Below I provide an update on a commentary I wrote on the subject of money supply and credit from a few years ago.
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The price of anything is measured in the form of dollars per unit whether it is $/share, $/bond, $/house, $/barrel, etc
(or whatever your base currency is). The price of everything comes down to those two things, supply of assets and
the quantity of money chasing those assets. More money chasing fewer assets means higher prices, and vice versa.
Asset price = quantity of money/supply of assets
While there are some exceptions such as a disruption in oil production, the growth in supply of assets tends to be relatively stable in the short run. So it is changes in the quantity of money that drives short term asset swings. There are two main ways in which the quantity of money chasing an asset can change. To illustrate, I show below a simplified system with $100 in money and 2 assets, a bond and a stock. To start with, let’s say the money is evenly divided between stocks and bonds and the price of each is $50.
First, money can flow from one asset to another because investor preferences change. For example, if growth numbers are bad, investors tend to incrementally move money out of stocks into safety assets like bonds. As money flows out of an asset, there are fewer dollars chasing the same supply of assets and prices fall. In contrast, as money flows into an asset, more dollars chase the same set of assets and prices rise. This effect is fairly intuitive and is what most people think of when asset prices change. I illustrate this effect below through our simple system.
Second, net money can be added or taken out of the system. This concept is a bit more nebulous, but its effect has dominated the markets in recent years. For example, during the multiple rounds of quantitative easing (QE), the Fed was essentially adding money supply through printing of cash as well as lowering of interest rates to promote additional credit creation. More money supply in the system tends to be bullish on average for all assets because regardless of investor preferences, there are simply more dollars chasing the same set of assets, increasing average asset prices. Alternatively, as the Fed ended QE and began to hike rates, money was taken out of the system and fewer dollars existed and average asset prices fell.
In our simplified example, QE would be akin to there being suddenly $200 in the system instead of $100. Given the same allocation between stocks and bonds, their average prices would double to $100.
Our world is of course far more complex than the illustration above, but asset prices fundamentally behave in the same way. Below I show again the more complex breakdown of global assets. Asset prices can change because of 1) flows of money from one asset to another and 2) aggregate change in the total money supply.
In most typical environments, it is the flow of money between assets that dominate price changes. I believe this is why most investors tend to focus on this mechanism of price changes. However, central banks have played an increasingly important role in markets by shifting the aggregate money supply. Now, both factors drive asset prices, often in opposite directions. This is part of the reason why asset movements have been more confusing than usual.
In the simplified example above, if I held either a stock or a bond, I’d be affected by both the flow of money between bonds and stocks and changes in aggregate money supply in the system. However, if I held a portfolio of both assets, I would not care as much about the flow of money between bonds and stocks and I’d only be affected by changes in aggregate money supply. This is largely true of our diversified portfolio. We are relatively agnostic to the flow of money between assets. Instead, our performance is largely driven by changes in the total money supply of our system.
So how would you measure money supply? When you go out and buy a house or a car, your total purchasing power is
the sum of the cash you have and the credit you can call upon. Therefore,
Money supply = cash + credit
M1 is a measure of all physical coins and currencies as well as demand deposits and checking accounts. I use M1 as a
rough proxy for cash in the system. Credit is a bit trickier but I use real interest rates as a rough proxy – as real
interest rates go down, credit creation becomes easier and vice versa. Below I aggregate these two into a rough proxy of change in money supply. There are of course more sophisticated methods but this proxy will give a quick and rough overview.
In 2004 and 2005, money supply in the system went down as Greenspan began to tighten. In 2008, money supply went down dramatically as banks failed and credit creation ceased up.
The 3 rounds of QE in the following years saw accompanying spikes in money supply growth. In 2013, money supply dropped dramatically as Bernanke hinted at ending QE and tightening. Money supply fell in 2015 as the Fed finally tightened. Money supply continued to fall as QE tapering began in 2017.
Given asset prices are driven by 1) flows between assets and 2) changes in aggregate money supply, how much does 2) drive asset pricing? Below I show the year over year change in asset prices compared to the change in money supply. The price of almost everything you can buy is somewhat correlated to the change in money supply and vice versa. Of course, sometimes 1) and 2) can drive assets in opposite directions. For example, despite a dramatic decrease in aggregate money supply in 2008, bonds rallied because so much money flew out of stocks into bonds.
The relationship between a diversified basket of assets and money supply becomes clearer because you average out the confounding effects of money flows between assets. Below I show the year over year change in price of a broad basket of assets (stocks, bonds, commodities, credit, and real estate) compared to the change in money supply.
As you can see, aggregate money supply is the dominant driver of average asset prices. Central banks have a far reaching impact because they control the supply of money in which everything is measured against. The force that drove virtually every asset to outperform over the last decade is now reversing. Average asset returns have been muted over the last few years and will likely persist in the near term.