The Looming Liquidity Crisis

I’m Jim Rickards’ chief financial strategist — and that brings a lot of responsibility. After all, Jim is one of the world’s most prominent financial minds. And I really need to be on my game in order to keep up with him. It’s hard, but rewarding work. Without that intro out of the way, let’s address why we’re facing a looming liquidity crisis…

Almost every Wall Street strategist will tell you that stocks are a sure buy as soon as the debt ceiling fight is resolved. “It’ll be back to business as usual,” they’ll say. “Earnings will start to grow again. And corporate balance sheets are healthy!”

In other words, good times will soon be here again! Well, all I can say is, not so fast. Good times wouldn’t necessarily be here again…

Sure, corporations have tons of cash. But that only tells a portion of the story. You can’t consider the corporate sector’s overall cash levels without reference to its total debt. Averages are dangerously misleading.

As the old saying goes, “You can drown in a pool that is, on average, a foot deep.”

When analyzing stocks, it’s vital to think about the entire pool, which is far deeper than a foot in many places. You can’t just consider averages. Again, the overall cash level is meaningless.

You have likely heard about stock buybacks, where companies buy back their own stock to reduce the available supply, which tends to raise the stock price. The Roosevelt administration actually made stock buybacks illegal in the mid-1930s, on the belief that they were a form of market manipulation.

60 years later, during the Clinton administration, under heavy lobbying efforts from Wall Street that had been going on for years, the ban on stock buybacks was lifted. But the buyback effect really took off after the Great Financial Crisis and the ultra-low interest rate environment the Fed created.

Here’s what I mean…

A significant portion of the last decade’s stock market gains were produced by corporations buying back their own stock. It was all enabled by the artificially low interest rates resulting from massive market intervention by the Fed.

Not to get too technical, but stock buybacks are only lucrative in a low-rate environment, falsely created or not. If you want to call it financial manipulation, I won’t tell you you’re wrong. But that’s the way markets have operated since the Great Financial Crisis.

Now, in fairness, I need to say that stock buybacks aren’t necessarily bad. For financially sound companies with plenty of cash on hand, stock buybacks might even be good business decisions. I don’t want to paint with too broad a brush here.

Again, stock buybacks aren’t necessarily bad. But they can be abused. Consider Apple…

Apple is buying back stock. But Apple’s free cash flow has already been shrinking for a few quarters. And it’s going to fall sharply in a recession. In other words, the Apple buyback scheme doesn’t mean it has plenty of cash on hand. It doesn’t indicate strong cash flow. Quite the opposite.

Here’s what’s going on, as far as I can tell:

Apple’s corporate finance strategists are selling high-cost debt to invest in low-yielding stock buybacks. Do you see the problem? They’re selling high-cost debt to invest in low-yielding stock buybacks.

That’s not a winning combination. Guess what?

Apple would be better off investing its cash in Treasury bills! Or, they could pay it out as a dividend to reflect the company’s limited growth potential. My point in discussing Apple is that if even mighty Apple’s balance sheet is weakening… what does that say about companies in lower-quality, more competitive businesses?

It says they’re likely to suffer lower stock prices as creditors take their pound of flesh from shareholders to refinance debts. This brings up another question, taking us into the weeds against our will: Why is the junk bond market holding up so well in the face of a high-rate policy from the Fed?

In case you don’t know, “junk bonds” are exceptionally high-risk bonds. They offer extremely high yields to attract investors — but that’s because they’re extremely risky.

So why are junk bonds holding up so well in today’s environment? Here’s my best answer: It’s just temporary. They’re ticking time bombs. Give it about three to six months before junk bonds reach the panic stage.

But let’s get back to things that supposedly “matter”…

The market’s narrative is intensely focused on the debt ceiling fight in Washington, D.C right now. Once that’s resolved, the bulls say we will get a “relief rally.” But relief from what, may I ask? This market has been complacent for most of the year, even in the wake of bank funding stresses. Sure, a few sentiment surveys conclude investors are bearish.

But action, not words, reflect a bullish mindset. We have seen no material fund outflows from stocks. In fact, net fund flows into stocks have been flat over the past year.

And getting down to brass tacks, the S&P 500 Index may rally on headlines of a debt ceiling deal. It probably will. But any such rally is unlikely to last. Why do I say that? The answer comes down to liquidity…

Markets are entirely dependent on liquidity. When liquidity is freely available, the stock market tends to outperform. But when liquidity is scarce, the stock market tends to underperform. Here’s where things get interesting…

In the coming months, even with a debt ceiling agreement, the Treasury will be forced to sell enormous amounts of bonds to finance its operations. Tax receipts alone can’t finance them. Where will the money come from to purchase the bonds?

That’s the supreme question.

Basically, we’ll be witnessing a vast wave of U.S. Treasury bill auctions. These will drain tremendous amounts of liquidity from Wall Street. For a stock market reliant upon generous amounts of liquidity, that is a poor sign.

So what can you expect next?

Around the same time as Janet Yellen is sopping up hundreds of billions of Wall Street liquidity via Treasury bill auctions, the jobs data will weaken as the lagged effect of the 2022 rate hikes kicks in.

Jay Powell will be slow to react to job market weakness. He may actually welcome a softer jobs market to a certain extent. Weaker demand for labor will help the Fed achieve its 2% inflation target, at least as the Fed sees it.

In conclusion, the combination of heavy Treasury bill auctions, a Powell Fed that wants a weaker job market, and tightening credit conditions is a nasty cocktail. The liquidity just isn’t going to be there, in my opinion.

Batten down the hatches, it looks like rough times are coming.